Q2 2022 Sixth Street Specialty Lending Inc Earnings Call
Okay.
Yeah.
Good day, and thank you for standing by walking through the sixth Street specialty lending Q2, 2022 earnings conference call.
At this time all participants are in a listen only mode.
After the speaker's presentation, there will be a question and answer session.
To ask a question during the session you will need to press star one one on your telephone.
I would now like to hand, the conference over to your speaker for today CAMI Van Horn you may begin.
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.
<unk> 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 and sixth Street specialty lending Inc. Filings with the Securities and Exchange Commission. The company assumes no obligation to update any such forward looking statements.
Yesterday after the market closed we issued our earnings press release for the second quarter ended June 32022, and posted a presentation to the Investor resources section of our website Www Dot sixth Street specialty lending dot com. The presentation should be reviewed in conjunction with our Form 10-Q filed yesterday with the SEC fixed or specialty lending.
<unk> 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 32022. 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 fifth Street.
Specialty lending Inc.
Jamie Good morning, everyone and thank you for joining us with US today is my partner and our President both family and our CFO incentives.
For our call today I will provide highlights of this quarter's results and then pass over to Bo to discuss this quarter's origination activity and portfolio.
Ian will review, our quarterly financial results in more detail I will conclude with final remarks before opening the call to Q&A. In addition, today's earnings call brief press release Investor presentation and Form 10-Q. We also published a letter outlining a number of perspective, we thought it would be valuable to our stakeholders.
Consistent with our approach to provide additional communication during the first few months of the pandemic. We wanted to share a framework to continue the confidence our stakeholders have place in the spirit of the stewardship of their capital given the outsized impact of that macroeconomic environment on markets and therefore, our business with that would be helpful or take the same approach with this quarter.
This earnings release.
We encourage and welcome any feedback.
After market closed yesterday, we reported second quarter financial results with adjusted net investment income per share of <unk> 42.
Corresponding to an annualized return on equity based on that adjusted net investment income of nine 9% inclusive of Mark and the fair value of our investments. We also reported adjusted net loss per share of <unk> 30.
Our adjusted net loss per share this quarter was driven overwhelmingly by unrealized losses as we incorporated the impact of a wider market spreads on the valuation of our portfolio.
Given its impact on our financial results I'd like to spend a moment on.
On the importance of our quarterly valuation framework as we said before we believe that intellectually honest framework for portfolio valuation as a bedrock for effective risk management.
Germany fair value of assets at a moment in time, you can input from the market is critical.
As a result, we have incorporated the impact of market spread movements into the valuation of our portfolio adjusted for the expected weighted average life and other and other idiosyncratic factors specific to each investment.
One of our most important jobs is capital allocation and this cannot occur without marketing are marking our assets appropriately. We will continue to follow the framework as we have since inception.
Confident allows us to make sound investment and risk management decisions based on the market signals.
We've laid out a framework more extensively in the letter I mentioned earlier.
Our investment income reflected a period, where our results were driven by the core earnings power of our portfolio with little contribution from activity levels driving other income 93%. This quarter's total investment income was generated through interest and dividend income compared to 85% across 2021 and seven.
9% across 2020.
The anticipated positive asset sensitivity of our portfolio combined with more normalized activity levels driving other income should further supplement our earnings results for the remainder of the year, providing support for an increase in our base dividend level, which I will discuss in a moment.
Unrealized losses during the quarter resort and resulted in a partial unwind of previously accrued capital gain capital gains incentive fees that we have discussed in prior quarters. Given this unwind is tied primarily to unrealized gains from our investments consistent consistent with how we've treated this line item and prior.
We've adjusted this quarter's results to exclude the impact of this noncash expense reversal, which was approximately <unk> 12 per share reported in net investment income and net loss per share for Q2 were 54 and.
And <unk> 18, respectively.
Due to the strength of our historical credit performance and generating cumulative net realized gains in excess of unrealized losses.
The remaining nine cents per share of capital gains incentive fee on our balance sheet will continue to provide a cushion to any negative impact of market spread movements on our net asset value.
At quarter end, our net asset value per share declined by approximately three 4% from $60 84, which includes the impact of the Q1 supplemental dividend.
2016 to 27.
As discussed the primary driver of this decline was 66 cents per share of unrealized losses from the impact of credit spread widening and lower implied equity values on the valuation of our portfolio.
Note this approach to incorporate credit spread movements within our valuation framework for the fair value requirement for Bdcs under the investment Company Act of $19 40 and is in accordance with GAAP.
He will walk through the other drivers of this quarter's net asset value bridge in more detail turning now to a few thoughts on the current market environment with the possibility of a recession on the horizon remain highly focused on our risk management framework.
Our investment and capital allocation decisions.
As we address those and other topics in our letter we will focus our time today on the impact of rising rates on our income statement, we expect to see meaningful positive asset sensitivity in the back half of the year. The combination of the rise in rates in Q2.
Now well above our average floor levels on our debt investments and the shape of the forward LIBOR so for curve.
That expectation.
Horizon rates will drive incremental interest income and outweigh the increases in the cost of our liabilities to date. This has been largely muted because as Paul referenced rate resets occurred during <unk>.
Occurred earlier in the quarter based on the shape of the forward curve and resets, we said Dave.
Our issuers that we project the remainder of this year that rate move alone will result in approximately 13 cents per share of incremental net investment income purely from the core earnings power of the portfolio portfolio relative what we experienced in Q2.
In addition, the extent to the extent received.
<unk> growth over this period, our core earnings power of our business will be further enhanced.
In previous periods of rising interest rates for example from 2017 for late 2018.
The reality of asset sensitivity has been causing question given the tendency of the BDC sector to sacrifice spread in order to prioritize asset growth.
Given the spread environment today are strong relative capital base and significant liquidity, we are well positioned to retain the asset sensitivity.
<unk> will provide an update on our full year guidance later on.
While we view the rising rate environment in a positive light with respect to our earnings profile. We are cognizant of the impact more broadly and our borrowers are variety rates, coupled with inflationary pressures on input prices and a more challenging operating environment as Bob will discuss despite these rising costs. The overall health of our bars.
Our financial position remains strong.
Based on our updated view of forward earnings yesterday, our board approved a third quarter base dividend <unk> 42 per share to shareholders of record as of September <unk> payable on September 30. This represents an increase of <unk> <unk> per share to our quarterly based dividend there were no supplemental dividends declared declared.
The weighted Q2 earnings based on our formulaic supplemental dividend framework, largely due to lower activity based fees during the quarter as mentioned earlier, the spread widening period, where valuations experienced downward pressure the nab now.
Limiter in our framework also served to retain capital on stabilized needed asset value. We would note that following dialogue with and feedback from existing shareholder our board approved a change the payment dates.
Payment data timing of our quarterly based dividend such that the record date and payment date will occur during the same fiscal quarter. This change has no material impact on our financial results for accelerate the payment of the base dividend by approximately 15 day of each quarter relative to our past practice with that I'll now pass over to Bo to discuss this quarter's investment activity.
Thanks, Josh.
I'd like to start by layering on some additional thoughts on the broader market backdrop and more specifically how it relates to the positioning of our portfolio and the waiver thinking about the current opportunities in the market.
Although we cannot predict the impact timing or severity of the fed's actions on the economy, we feel confident that our portfolio is defensively positioned for a couple of important reasons first and foremost we follow a differentiated approach to underwriting which includes analyzing and understanding among other things the unit economics of our portfolio companies.
We are heavily invested in businesses that are characterized by having predominantly variable cost structures strong recurring revenue attributes high switching cost and low customer concentration.
We believe these fundamental characteristics will be key in the ongoing inflationary environment as we expect companies with pricing power and variable cost structures will be better positioned than those with large exposure to commodities.
High fixed costs and limited ability to pass through price increases.
Secondly, we remain invested at the top of the capital structure with 90% of our portfolio by fair value in first lien loans.
In this environment with market expectations, indicating the credit losses are likely to increase we feel that our positioning at the top of the capital structure in defensive industries will serve to preserve our capital and support a robust return on equity profile.
Our top two industry exposures are business services, followed by financial services at 14, 7% and 11, 5% of the portfolio at fair value respectively.
Note that the vast majority of our exposure to financial services are <unk> integrated software payment businesses with limited financial leverage and I don't know lining bank regulatory risk.
We present, our industry exposures based on the end market that are served from a broader lens approximately 81% of our portfolio companies represent software and services oriented businesses with high levels.
Our recurring revenue and resilient business models.
Until ABL exposure remained relatively low at five 9% of our portfolio on a fair value basis at quarter end. However, we expect to be inflationary environment and high rate environment will likely create interesting opportunities for us to become more active in this space.
Now I wanted to spend a moment on how were viewing investment opportunities and portfolio activity against the current market backdrop during the quarter high yield in broadly syndicated loan markets were mostly on the sidelines given the environment.
The liquid markets were quick to react the private markets have been much slower to reprice and largely remain in a period of price discovery between buyers and sellers in terms of valuation.
We anticipate there'll be more opportunity to provide direct lending solutions as sponsors remain active in looking to deploy capital as well as privately held companies looking to bolster their balance sheets.
Our omni channel approach to sourcing is critical in driving these opportunities.
With the potential for increased deal flow in the second half of 2022, we continue to be very selective with our investment opportunities and have set a high bar for allocating our capital during this period as.
As we said in the past our primary priority is generating attractive risk adjusted returns for our shareholders, which requires us to be disciplined in our approach to.
To deploying capital.
As it relates to the portfolio activity, we had $379 million of commitments and $325 million of fundings across eight new investments and upsized to two existing portfolio companies during the quarter.
Consistent with our focus on maintaining a defensive portfolio. Our two largest investments crunch time in America, where in software services companies with deeply embedded underlying products, resulting in high quality recurring revenue basis.
Crunch time was our first lien term loan where our relationship with a company from our previous successful investment that we exited in 2017 allowed US to act quickly to support the acquisition of <unk>, a highly complementary business to <unk> Enterprise management solutions.
As for our investment in Merit have formerly known as IBM Watson Health care business, we partnered with Francisco partners to provide a funding for a complex transaction involving the carve out of certain software assets.
We leveraged the power of the <unk> platform as well as our deep relationship with our sponsor to provide a financing in the form of a senior secured credit facility to support the acquisition and carve out with speed and certainty of execution.
Both of these investments followed our thematic approach of underwrite writing in the underlying sectors and industries that we believe are defensive and stable in the current environment.
Notably although.
We only closed the Meredith transaction at the end of June .
Pricing in terms of this transaction, we agreed to back in February and it was at that date that becomes a reference state for determining the impact of spread movements through the end of Q2.
While there has been no deterioration in performance that approach has resulted in an unrealized loss on the name alone for a fair value determination of approximately <unk> <unk> per share in Q2.
Other new investments during the quarter include several new deals and upsize it to existing portfolio companies, such as staples as well and the investment in energy space to merchants in the oil and gas, which increased our energy exposure to 32, 2% of our portfolio on a fair value basis as of the quarter end.
Similar to prior periods of market volatility, we made purchases of double and triple B, CLO liabilities, which comprised approximately $29 million of fundings during the quarter as one of our core opportunistic investment themes at certain moments in time. These investments presented efficient use of capital on their return profile repurchase.
These securities at a significant discount to par with a yield to three year recovery of approximately 12, 5% with significant subordination to protect against future credit losses, we believe our expertise in the structured credit market further highlights the benefit of the broader <unk> platform in terms of providing tfl acts with differentiated deployment opportunities.
Especially in times of market dislocation.
Moving onto the repayment side, there were 12 $212 million of pay downs across six full and one partial investment realizations of six full repayments to where paydowns driven by refinancings, which we participated and thereby offsetting the paydown with subsequent new fundings during the quarter.
Although the repayment activity in Q2 was in line with historical averages the vast majority of our paydowns occurred during the first month per quarter.
As spreads widen more meaningful in the back half of Q2, we saw a slowdown in repayments, resulting in lower activity based fees.
For reference 65% of repayment activity during the quarter occurred in April our largest payoff eliminate occurred on April one and represented 30% of total repayment activity.
This investment generated an 11, 5% IRR and a $1 five X MLM during the whole period of four six years, reflecting the older vintage nature of the payoffs in Q2 resulted in limited OSV in the quarter's net investment income.
Supporting the performance of our portfolio. This quarter was the announcement on may 10th of Pfizer acquiring all the outstanding shares of bio hearing our weighted average mark on bio Haven increase from 104% to 111% during the quarter.
Reflecting the impact of the <unk>.
Dissipated fees embedded in our underlying exposure to the portfolio company.
While incorporated into Q2 fair value Mark we expected fees will eventually flow through investment income at the time of payoff, resulting in the crystallization of activity related fees.
Increasing our capital base, and creating incremental investment capacity for new deployment opportunities.
Our weighted average yield on debt and income producing securities at amortized cost was up to 10, 9% from 10, 3% quarter over quarter and is up about 80 basis points from a year ago.
The weighted average yield at amortized cost on new investments, including upsize as this quarter was 10, 1% compared to a yield of nine 5% on exited investments.
Moving onto the portfolio composition and credit stats across our core borrowers for whom these metrics are relevant we continue to have conservative weighted average attached and detached clients on our loans at 0.8 acts and four for fixed assets, respectively, and our weighted average interest cover coverage remained.
<unk> stable at two six times.
As of Q2 2022, the weighted average revenue and EBITDA of our core portfolio companies was $140 million and 130.
$140 million and $34 million respectively.
The performance rating of our portfolio continues to be strong with a weighted average rating of 113 on a scale of one to five with one being the strongest representing no change from the prior quarter.
We continue to have minimal non accruals at less than 0.01% of the portfolio at fair value with no new names added to non accrual during Q2.
The stability of these metrics quarter over quarter illustrates that there has been no deterioration in the underlying credit quality of our portfolio.
Historical data is important we recognize what really matters is future performance. We believe we've done a good job positioning our portfolio to date, but as always as time will tell.
Finally, the strong pipeline that we referenced during our last earnings call continues to provide us with attractive deployment opportunities.
Given our strong liquidity and capital position that has proved to be a competitive advantage relative to peers that operated operated with higher levels of financial leverage. We expect this we expect this aspect to extend in the current period of volatility is access to capital they become more constrained with that I'd like to turn it over to Ian to cover our financial performance.
<unk> in more detail.
Thank you Bo.
Q2, we generated adjusted net investment income per share of <unk> 42, and adjusted net loss per share of <unk> 30.
At quarter end total investments with $2 5 billion up slightly from the prior quarter as a result of net funding activity, partially offset by the impact of lower valuation marks on our portfolio.
Total principal debt outstanding at quarter end was $1 3 billion and net assets were $1 2 billion or $16 27 per share.
Our average debt to equity ratio decreased slightly quarter over quarter from <unk> 95 times to <unk> nine times and our debt to equity ratio at June 30 was 106 times up from nine one times at March 31.
The decrease in our average debt to equity ratio was driven by repayment activity in the beginning of the quarter with leverage dropping to a low of <unk> 86 times in the April as Bo mentioned, we saw a pause in repayments in the latter half of Q2 and increased fundings. During the last few weeks of the quarter, resulting in a higher reported leverage metric at June 30.
More specifically net funding activity in isolation would have resulted in a leverage ratio of 1.02 times at quarter end with the Delta to our reported quarter in figure of 1.06 time being the impact of valuation marks on our investment portfolio.
Before turning to our results I would like to reiterate the strength of our liquidity funding profile and capital position at quarter end, we had $1 2 billion of Undrawn capacity on our revolving credit facility against only $155 million of unfunded portfolio company commitments available to be drawn based on contractual.
<unk> in the underlying loan agreements.
In addition to having significant liquidity, we remain well below the top end of our previously stated target leverage of one five times, providing us with the ability to capitalize on attractive investment opportunities for our shareholders.
We believe this combination of liquidity and our capital position, which proved its value and importance during the pandemic physicians as well across varying operating scenarios and enhances our competitive positioning.
Our capital allocation framework remains top of mind for us as well given current market dynamics and we've elaborated on this subject in our letter.
As it relates to our debt maturity profile and any impact on liquidity. The remaining principal value of our convertible notes settled on Monday August one with no material impact on our liquidity.
As mentioned in prior quarters earlier this year, we elected to settle the converts primarily with stock, resulting in an equity issuance earlier this week of approximately $4 4 million shares.
Close to 80% of the outstanding principal amount was settled in stock and the corresponding equity issuance translated to approximately <unk> <unk> per share of accretion to our net asset value, which will be reflected in our Q3 financial results.
This transaction improved our capital positioning by lowering our leverage ratio and increasing our capital base, thereby creating additional capacity to invest in interesting new opportunities as they arise.
Quarter to date, our net funding of new investments amount to approximately $145 million pro.
Pro forma for the settlement of these convertible notes early this week and inclusive of the impact of net fundings and broad market credit spread tightening of approximately 50 basis points since quarter end, we estimate our current leverage is 104 times with liquidity of approximately $1 billion after.
After the settlement of these convertible notes our funding mix is comprised of 57% unsecured debt and 43% secured debt.
Moving to our presentation materials slide eight contains this quarter's NAV bridge.
As Josh mentioned the impact of credit spread widening on the valuation of our portfolio was by far the most significant driver of NAV movement. This quarter with unrealized losses of <unk> 66 per <unk>.
Sure.
Again absent permanent credit losses, we would expect to see a reversal of these unrealized losses related to credit spreads over time as our investments approach their respective maturities.
The estimated impact of broad market credit spread tightening since quarter end that I referenced earlier.
Presents approximately <unk> 16 per share unwind of the unrealized losses, we saw during Q2.
Walking through the other drivers of AAV movement. This quarter, we added 42 per share from net investment income against the base dividend of <unk> 41 per share it.
There was a <unk> 12 per share uplift related to the unwind of previously accrued capital gains incentive fees, which Josh also mentioned earlier and.
And finally, there was a <unk> <unk> per share decline in NAV from the unwind of unrealized gains as a result of Paydowns.
Moving onto our operating results detailed on slide nine total investment income for the quarter was $63 9 million compared to $67 4 million in the prior quarter.
Walking through the components of income interest and dividend income was $59 1 million up slightly from the prior quarter driven by net funding activity during Q2.
The fees, representing prepayment fees and accelerated amortization of upfront fees from unscheduled pay downs were lower at $3 2 million compared to $6 9 million in Q1, given the lower impact on income measures from repayment activity that we highlighted earlier.
Other income was $1 6 million compared to $1 8 million in the prior quarter.
Net expenses, excluding the impact of noncash accrual related to capital gains incentive fees with $31 4 million up approximately 5% from prior quarter.
The increase in net expenses quarter over quarter was primarily driven by the upward movement in reference rates, which increased our weighted average interest rate on average debt outstanding from two 3% to three 1%.
There is a lag to the impact of rising interest rates on the weighted average interest rate on average debt outstanding and the increase this quarter is largely explained by the movement in base rates from the prior quarter.
Before I discuss our guidance for the remainder of the year emerging for those that track. This metric as of the end of the quarter. We estimate that our spillover income per share is approximately <unk> 56.
Year to date through June 30, we have generated adjusted net investment income per share of <unk> 90.
Corresponding to an annualized return on equity of 11%.
This compares to the target return on equity that we've articulated throughout 2022 of 11% to 11, 5% or $1 84 to $1 92 on a per share basis.
Based on the impact of the positive asset sensitivity in our business that John referred to earlier, resulting in higher anticipated net investment income combined with a strong overall health of our portfolio, we expect to exceed the top end of our target range for full year 2022.
With that I'd like to turn it back to Josh for concluding remarks.
We hope people take the time to read our letter as we outlined what we really think marathon driving shareholder returns.
<unk> isn't one of our strengths we apologize in advance with a clear understanding of what is important in driving the results of our business.
We'll continue to create value for our stakeholders and serve our portfolio companies management teams and financial sponsor partners with creative financing solutions in closing I want to wish everyone. A wonderful rest of the summer with their friends and loved ones with that thank you for your time today operator, Please open up the line for questions.
Thank you.
As a reminder to ask a question you will need to press star one on your telephone.
Please standby, while we compile the Q&A roster.
Once again Thats star one one to ask a question.
One moment for our first question.
Our first question comes from the line of Finian O'shea with Wells Fargo. Your line is open.
Hi, Good morning. Thank you can can you tell us about the new BDC fifth Street has on file.
Fall within the same origination line is <unk>.
Or otherwise how would.
The investment style compare.
Okay.
Good morning, Finn how are you.
Look we're obviously limited on what we could talk about given the private placement rules.
What I would say is.
A completely different investment strategy and sixth street specialty lending.
And so there should be limited overlap.
And what we as you know for the last.
10 years, I guess 12 years since we formed <unk> III, especially lending.
Our sole focus and our continued focus will be on creating shareholder returns.
Obviously.
The direct lending market has opened up significantly.
<unk>.
And there are areas in that market given the.
<unk> capital base and our.
Unwillingness raise equity all the time that we can be involved in but given that private placement rules is hard to talk about at this moment.
But I assure you that it will have no impact on <unk>.
600 specialty lending focus.
Or cannibalize its opportunity set anyway.
Okay. That's helpful. Thank you.
As a follow up one of your BDC peers, yes.
Yesterday lowered its.
Hey speed.
To accrue on SM.
Essentially instead of assets.
This week seeing if you have any sort of initial thoughts on what it might.
You mean for the industry, how you think about it.
Okay.
I can tell us argue things.
I'll try not to say snarky things.
One is I think I think that Pierre had a long history of problems on the performance side and also changed investment strategy over time I think when you look at the yield on their investments and you think about just the simple portfolio yield minus the fee.
I think our debt investment portfolio is $7 seven yield the effective fee now given NAV is like 70 basis points.
And so net yield.
Here to leverage and prior to incentive fees is like 7% right.
Other costs when you look at the portfolio I think our yield at amortized cost.
$10 $10 nine doing the same math adjusted for one 5%.
It gets you to 90 494, so we're still 240 basis points higher prior to accounting for skills related to credit loss and quite frankly that we're running and we're generating.
Our return on equity I think pro forma significantly higher and using less financial leverage to do so so.
Look they have added change of strategy over time, they've put a whole bunch of spread compression in our book and they had performance issues on the credit side, so its not shocking.
It might be appropriate for that strategy.
And then the last thing I'll say is well confused about that.
The purchase.
Now given that the stock price is way below NAV and is that I understand.
The affiliate is owned by other people too so that's a little confusing, but I'm sure. There was reason to do that.
Very well thanks, so much.
Thank you.
Please standby for our next question.
Our next question comes from the line of Mickey <unk>.
With Ladenburg your line is open.
Good morning, everyone.
Josh in the prepared remarks, I think I understood that you said.
Youre seeing come where you expect your fee income to be to improve in the second half of the year.
Could you just help us reconcile that against a rising rate environment, because typically we would expect rising rates to to limit prepayments.
Then as a follow up to the question why were fee.
Fee income a little light this quarter relative to historical levels.
Yeah. So first of all I think we don't want a mortgage book, So I think thats true mortgage land I think it spreads that matter.
So but your point is taken if you think about widening spreads is that we don't have a rate sensitive book compared to prepayments, we have spread sensitive book compared to prepayments and so obviously spreads well borrowers have.
Yeah.
Access to.
They have they.
They have spreads that they don't want to Opportunistically refi.
And valuations and public valuations for <unk>.
Divot sellers.
Buyers and sellers of private businesses.
It needs time to figure out a new valuation so I would say two things on the forward. One is even though spreads are widening we expect M&A to increase overtime and so some of our portfolio will ultimately churn, but there is this period into the private markets, where that doesn't happen given the valuation disconnect and then the other item, which is I think.
It is clear and been announced.
That bio Haven.
And.
I'm not I'm not part of that management team and part of the acquirer, which I think is Pfizer.
I don't want to speak to the timing of that but that's the change of control transaction and there is significant call protection in that and so that will be rolling through as of Q4 or whatever back half, but its going to be most definitely rolling through and so I think the combination of that we expect M&A market saw.
In Q2, as M&A markets and there is and there is there are.
People certain buyers and sellers.
Hi.
Portfolio churn will increase a little bit and then we can look at our book and look at the idiosyncratic things such as bio Haven that we have visibility into.
I appreciate that.
I understand John Josh One last question.
If we look at the leveraged loan market sort of as an indicator of where defaults might go the distressed.
<unk> ratio is a little north of 3%.
Looking at your Crystal ball out for the rest of this year and going into next year.
Do you expect a false to climb to those levels and how do you expect your portfolio to behave.
In terms of credit.
Given the trends that we're seeing in the economy.
Mickey you hit it.
Add on which is I think if people who read our letter.
What we've said is there is no free ride broad based free ride, we think our portfolio behaves differently on rising rates rising rates will lead to a default cycle.
Especially if you believe we're in some saturation dairy environment, where there's inflation, but very well growth.
And if you look at credit spreads as a proxy credit spreads are telling you that the cop.
That return needed extend credit should be higher given.
Of course back of defaults and losses, So I think.
I have a crystal ball on what that number is.
But there's a whole bunch of ways to do the math.
If you think that historically.
The average single B has had a net spread post losses of 200 to 250 basis points. You can look at the losses going forward given spreads there's a whole bunch of ways to do the math, but directionally I think most definitely defaults and losses are going to increase and investors in this space in the BDC space can only net investment income.
Less realized losses, so I think that's really important.
Second thing is our portfolio is really defensive top of the capital structure I think 80% was in the prepared remarks are basically business services software, whether it's recurring revenue and variable cost structure and really no.
<unk> et cetera to inflation and so I think we feel really good and quite frankly pricing power and so I think we feel really good about where our portfolio is headed in.
In addition to all of those things and the attributes why those why they have those attributes like pricing power is because.
Theyre solving problems for our portfolio companies are solving problems for their customers that our ROE and valuable to them.
If you look at our portfolio I think year over year.
Portfolio growth was about 31%.
Quarter over quarter was about seven two for 28% annualized so you surely there's still strong portfolio grow.
Revenue growth in our portfolio companies in our core portfolio companies. Although it is clearly the decelerating, but our portfolio companies have much more level levers on the cost side, given the variable cost nature. So I feel pretty good about our portfolio I felt pretty good about the forward earnings power of our business.
Given the inflection on rising rates.
And.
So.
I'm positive and quite frankly, we have a whole bunch of embedded earnings power in our business given that we have more capital more liquidity in this space to take advantage of.
Better lending environment.
I am excited.
I appreciate that Josh Thanks for all the transparency.
We certainly appreciate it very much.
Thats It for me this morning.
Thanks Vicki.
Thank you please standby for our next question.
Our next question comes from the line of Kevin <unk> with JMP Securities. Your line is open.
Hi, Good morning, and thank you for taking my question you touched on this a bit in Mickey's question clearly portfolio credit quality is in excellent shape with non accruals at cost, 1% just curious from where you sit Josh and how you think about things are there certain verticals that you see is more at risk in the current environment, whether that's you.
Inflation labor issues geopolitical risks or recession peers.
Monitoring more closely at the macro environment continues to evolve.
Yes.
A great it's a great question.
So yes.
Positive on our portfolio and look we've been thoughtful about how we've built that portfolio and the characteristics of those companies and where we invest in the capital structure.
If you take a giant step back.
And.
What's happening in the world today.
The policymakers.
<unk> get inflation under control the only way to get inflation under control is effectively the kill the consumer.
Unfortunately.
And part of <unk>.
Consumer.
Restricted restrictive monetary policy, which takes dollars out of their pocket and also increase in the cost of capital to companies for them to make investment decisions and hiring decisions et cetera. So you can expect that employment unemployment is going to rise the consumer's going to get in worse shape, I think I saw a headline yesterday, where consumer debt.
And credit card desktop et cetera, So I think we're in a really tricky environment.
The question is can the fed gets to a soft landing where they can kill the consumer enough.
Yes.
The land that had the land the plane on the proverbial ahead of a needle.
Not Kelly economy, and I think the market is kind of trying to figure that out our portfolio generally is a <unk> portfolio.
And so we don't have a whole bunch of consumer we don't have any retail outside of ABL, we don't have any.
We don't have the cost structure of our business don't have.
A whole bunch of commodity inputs have been have inflation, where they can't price on that again.
We don't have those that nature of that portfolio company, where those commodities and the cost structure.
Be aware of low margin.
Businesses.
That have measured by EBITDA margins or EBIT margins that have commodity inputs are those are those businesses that are affected by inflation, they probably don't have pricing power.
And those businesses that have are around consumers.
I think youre going to be challenged going forward too as well so I feel.
Relatively good about again, our portfolio positioning but.
Our world and the economy very interconnected I tried to talk about this in our letter.
And.
<unk> is going to be affected too, but most definitely I think we have a more insulated defensive portfolio.
Okay. That's all really helpful. Josh and thank you for taking my questions I'll leave it there.
Okay.
Thank you please.
Please standby for our next question.
Our next question comes from the line of Kenneth Lee with RBC capital markets. Your line is open.
Hey, good morning, and thanks for taking my question.
Just one on the CLO investments you mentioned you talked about it being an efficient use of capital just wondering whether you could just further flesh out how these investments compared with your more traditional debt investments.
And as well how do you think about the risks, especially under potential macro deterioration.
Compared with most of your other debt investments. Thanks.
Yes, yes.
Great question. So first of all we've had this strategy in place over time I think we invested in a bunch of 15 16, we.
Did it in Covid I think we may have done in 2019, when there was the market blip.
Where a lot of the there is a lot of forced selling coming out of those markets because they're held by mutual funds.
And so.
People have to be forced sellers when you look at the loss taken ability in those securities.
You have to think that broadly syndicated loan default rates are very very high and stay high for a long time.
And so you have less idiosyncratic kind of insight, although we got a portfolio by portfolio and look at the underlying names. Although the underlying names can change if they are in their reinvestment period, but historically when you look at.
They have greater loss taken ability.
Around defaults, although not on an idiosyncratic basis.
And when you look at the private loans.
Usually had offered about a 400 basis points.
Our premium to double BS and a 200 basis point premium.
A 400 basis.
Premium Triple visa 200 basis point premium to <unk>.
And when you look at the environment that we've been in that environment is now the premium was flat to negative 300 basis points and so the relative value was really really wide and the yields the recoveries were in the kind of low teens.
And so we just think it's a much more efficient use of our capital and quite frankly.
And it's also a source of liquidity.
Unlike private loans, which can never be a source of liquidity. So.
<unk>.
We like that we've done it we have a team.
Let us focus on it and.
We think we have unique insights.
So.
Again, we're focused on efficiently using our shareholders capital to create total returns both on a spread basis and on a.
And on a capital appreciation basis.
You can buy a triple B security at 90 or 89.
With a lot of loss, making ability we're the world would have to and if it was ever in default and I think historical defaults have been or losses had been zero and triple BS.
Again at with 10 points of OID.
And with.
As good as risk.
Spread.
It just seems like a no brainer.
Gotcha very helpful. There.
One follow up.
I may just on the the valuation changes.
It sounds like from the prepared remarks, a lot of it was.
Spread driven.
Wondering.
How much.
It is socratic factors drive some of the fair value changes within the portfolio.
Yes, so our group them in really two categories.
And in two categories being broad based spread movement and then as you know we have a small equity book and equity premiums risk premiums widen as that as well. So there wasn't really any performance based markdowns broadly in the book. The book is performing as a combination of on the equity instruments, we have.
Valuations came down now.
And kind of if you think about corporate finance they should earn this should generate a return.
From a go forward basis from the troughs valuation, but it's less visible because equities have longer duration.
And don't have a maturity.
And then the other bucket is the credit spread which is quite frankly.
Right on credit all of those.
All the all the unrealized losses I went through the books yet.
So actually unwind at some point, we will get our par backup maturity or before maturity for those should all unwind.
There is not really any broad based performance Mark Downs in the book It was a combination of spreads widening and on our equity book equity valuations came down.
Got you very helpful. There. Thanks again.
Thank you.
Please standby for our next question.
Our next.
Comes from the line of Robert Dodd with Raymond James Your line is open.
Hi, good morning, Thanks for all the color on the NAV.
That's quite interesting.
One.
No not on that topic.
When you look at <unk>.
Can you have generated a lot of a lot of.
Income from some some fee structures a lot of call protection.
The way you structured loans et cetera.
Maybe not in this environment, but over the next couple of years do you expect any any push back from boys on the amount.
Kind of call protection you embed.
Given how competitive the private credit market.
Is increasingly getting all cases, frankly, the borrower doesn't care that much because of the cold protections usually paid by an acquirer in an M&A event.
So I'm not sure the call protection is made by acquire an M&A event. It comes out of the seller proceeds so put that in.
No.
So.
Put that in.
The sellers capital structure, they bear the cost of the.
Capital structure.
I would say first of all I think the premise of that the competitive environment I think is changing.
Significantly or on the margin significantly more than we've seen historically, which is.
I don't know if its lack of retail flows in the products or people being at the top end of their leverage and so there is less capital, but we have seen spreads increase.
We thought the end of the quarter Thats, what why we reflected in our book along with broadly syndicated loans and we're seeing it now and so we're re seeing reinvestment spreads increase and so the world and we're seeing fees go up and we're seeing leverage go down and so the world is becoming a better kind of a better place for lenders. My guess is it's also become.
A better place for buyers on the private equity side, because they're buying at lower valuations and so.
I think generally I think terms are being more lender friendly.
And sellers are getting buyers are getting better terms given that.
That change in the valuation environment.
The one thing I would say is when you look at kind of as a proxy for how much.
How much.
NAV increase is embedded in our book the fact that the metric that we post that you should look at is.
Fair value of the portfolio related of call protection.
How are you.
The book if the book Mcquaig date today, how much is rolling through.
Either.
<unk>.
The unrealized and realized gains traction and how much and some of that will walk through the investment income line.
This quarter I think is and.
Part of this is because of the markdown was $94 one.
So last quarter was $95, one and so when you look at our book as it relates to <unk>.
Where people are creating and as a percentage of core price is the cheapest it's been at least in the last five quarters I have been looking at it.
Got it got it.
Do you look at that line.
Obviously that that to a degree the call protection goes.
To a degree I mean, it goes down over time as assets age.
In many cases.
Have you changed anything on the <unk>.
You probability weight call protection et cetera, when you're coming out with their values et cetera. There is any change on that piece of the framework in terms of.
That's absolutely right.
Alright, Thank you we've come up with fair value.
Thank you for your question was that have we changed.
We probably when you look at our fair value of investments.
<unk> has been weighted average life of our book increase a little bit and therefore, the probability of call protection has decreased because the call protection is a melting ice cube I think my question just I want to make sure I get question. Yes. The answer is yes on the margin given the wider spread environment.
The weighted average life is most definitely increased a little bit.
Got it thank you.
Thank you.
Please standby onto our next question.
Our next question comes from the line of Melissa We deal with Jpmorgan. Your line is open.
Good morning, and thanks for taking my questions and I'll reiterate prior comments about appreciating the shareholder letter.
You guys.
Posted with a lot of detail about how youre thinking about the environment.
Hi, I wanted to follow up on a comment you made earlier about sort of expecting an elevated pipeline, perhaps in the second half.
And I wanted to touch on that a little bit more.
Do you think it would be fair to say that given the rate environment.
Lot of companies wouldn't necessarily want to be in the market in the second half than what they had Q, so perhaps the pipeline might be.
A little bit more stress and what we've seen.
In the first half and if so.
How you're mitigating that.
Yeah. So.
<unk>.
I think it's really interesting because in both should comment on this.
The there is a ton of private equity dry powder so people.
Sure.
There are buyers are willing to transact and we're seeing that if you look at first quarter net fundings.
Was $150 million, so whatever excess in correct me if I'm right.
This Q3 quarter to date.
In July by July was 150 million Bucks.
How would you about the demand for credit on the M&A side that are historically relates to net fundings on average between.
Now, 50% and 75 million Bucks I think.
And then that things were already up a 150 million Bucks July to date, we have already used.
Effectively we use.
We ended the quarter at one point of onetime approximately <unk> debt to equity were one times debt to equity after the after the converts so we've used capital.
And when you look at I don't think there is we've been I think we're probably we're.
We're busier now than we were in the last 12 months and so you have a combination of there is a whole bunch of private equity dry powder in the system.
And you've now had time or buyers and sellers start Fianna II on valuation, where sellers don't say that himself.
No.
And their mind I'm going to buy the depth that things are going to change. They are now starting to capitulate a little bit.
Public companies are Capitulating on take privates and there is capital out there on the private equity side. So.
Lending in terms of getting better and valuation terms for the buyers are getting better and so that kind of all works. So I'm pretty bullish about the opportunity set going forward and were positioned with at the low end of.
Our target target debt to equity and we're positioned at the low end of the space, we have more capital and more liquidity than the rest of the space I mean.
I think one competitor who was at one five times debt to equity who cut their fees will have a different strategy I think gary's was at 102 facts.
And so we're we have relatively more capital more liquidity for our balance sheet than the space and so.
Im jazzed about the forward with wider spreads and a higher base rate environment, and a high quality portfolio and so Paul I don't know if anything that I think it took all of your Thunder.
All of it but yes, the only thing I would add is that look we will see a lot of opportunistic M&A and we're seeing that the pipeline is as busy as it has been in quite some time with opportunistic M&A both from a private equity world that are seeing values that have come down and also from the corporate world.
The best businesses are actually bolstering our balance sheets to be on the offensive and then lastly.
The markets have been very cheap over the last.
Three to five years and good businesses are now turning to the credit markets to bolster their balance sheets versus raising very cheap equity. So that combination has us quite bullish on the opportunity set in the second half of the year combined with a much more favorable lending environment, we're seeing leverage come in.
<unk> pricing and fees go up.
Yes.
Adam.
We actually hit it better than I did.
Yes.
All very helpful. I appreciate that and then to follow up on it given the bullishness of the team.
<unk>.
And the capacity that you have from a leverage standpoint.
Just wanted to clarify like where you would be you would be comfortable taking roborate portfolio leverage up to start at the higher end of that target range.
In this environment given.
Sort of greater macro risks, but also I also wanted to clarify one is that the case in Q.
How are you thinking about leverage is that.
Sort of on balance sheet or is that also inclusive of the undrawn commitments, which you also touched on in that shareholder letter. Thank you.
Yes.
Really great question complicate question. So I don't think were going to take it up.
But I would tell you is I don't think we're never going to take it up to one five times the way, we think about our balance sheet as we reversed we reserve for unfunded commitments, we have to make.
This is on the capital side. Some of this is applicable to the liquidity side to reserve for unfunded commitments.
That reduces our capital when those get funded and increases our leverage.
We reserved for.
A credit.
Credit spread widening that reduces our capital on a mark to market basis.
And we like to have dry powder to make investments in our capital structure and make.
New investments and so.
That's one.
105 to one two it's kind of in that range.
It's it's a moving target because it is a function of unfunded commitments.
That we have as well given that we have to burden our capital and burden of liquidity for that if you look at our business and you take a step back and say what is the constraint in our business as a cap or that liquidity.
The constraint is capital.
We're not capital constrained so don't read it that way, but like we have.
If we have more liquidity given our our financial policies than we do when we do capital on the on the margin.
So it's kind of in that range, but it's a moving target and in times like today, we run balance sheet daily or weekly and overlay our forward pipeline.
We're pretty thoughtful about how we put our capital work.
And understanding our own cost of capital because I think thats the path to shareholder value creation.
Got it thank you Josh.
Thank you.
Please standby for our next question.
Our next question comes from the line of Ryan Lynch with <unk>. Your line is open.
Hey, good morning.
First question I had was you mentioned the investments you made in some close in the quarter kind of a two parter on that one is that opportunity set still exist in the marketplace today.
And then also it sounds like Youre seeing a ton of opportunities just in the private markets, but are there with the dislocations, we've seen in kind of a liquid markets, which obviously contribute to the <unk>.
Opportunities in the CLO market are you seeing any direct opportunities to invest in any secondary positions, whether that's any sort of leveraged loans or high yield bonds of this marketplace or is it just limited right now.
Close.
Yes, so I.
I think.
630 was kind of a low point on <unk>.
And I think we were flat basically.
<unk>.
On those purchases during the quarter and then things have come up on prices two to three points or something like that so we haven't made any additional purchases.
And then as it relates to <unk>.
Secondary purchases of names, where most definitely looking.
I don't think they offer a strong relative value.
As the CLO.
Sure again this is not CLO equity this is not like first loss in the capital structure.
This is a this is where there is protection against losses.
And the structure.
And then on the margin all things being equal when you think about kind of how we would like to use our capital we like to use our capital support our clients.
If it makes sense on a relative value basis, so like when I think about the pecking order.
How should we think about.
If we are getting paid enough I, rather do it in private loans, because thats, our business and our <unk> clients.
Again, if we're going to do on liquid stock.
Looking at relative value and again.
The relative value of it seemed like a no brainer.
And in that and at that moment of time.
And we've done this over history in.
We've got a pretty good job of it so.
But on the margin I, rather use our capital to support our clients.
But we have most happening we've got probably syndicated loans.
High yield tougher for us just because.
Youre, making an implicit rate right back and they are longer duration.
The thing we generally like about private credit the last thing I'll say is that it does have a shorter weighted average life.
And so your spread per weighted average life. If you think about that metric is.
Is very attractive.
Versus high yield Youre discount margin the weighted average life is less attractive so and probably syndicated loans as well.
They're kind of setup. So they don't have to talk.
Their lenders.
Okay understood.
Another one that I had was you.
Mentioned, a lot about your portfolio of companies, having variable cost structures.
Can you can you explain what that is exactly I'm not sure if you're referring to maybe your software businesses.
Let's assume that if that's the case, maybe it's more like sales and marketing to make it make a toggle on and off but I'm. Just curious what is the variable nature of these cost structures.
At.
Tommy.
Bingo.
Okay, Okay. Okay. Okay.
Okay, and then just one clarification for distribution just to make sure.
The commentary you gave with a 13 cents of additional earnings in the second half of 2022, given that the shape of it.
Where LIBOR is today and kind of the curve LIBOR So I.
I just wanted to be clear that that is the cumulative amount that you guys would expect over the second half.
2022, and I would assume that that would be kind of that would build throughout the last few quarter. So 13 in total.
Rough estimate you could say like.
Five cents in Q3, and <unk> four something like that.
Youre spot on Brian .
Ryan the way to think about it is the.
Effective LIBOR in our book.
This past quarter.
Weighted average effective LIBOR was like 107.
No one's asked we had which was right above our forward, we had very little asset sensitivity in our book.
<unk>.
On a bottoms up basis people can correct me, if I'm wrong, we werent reset by reset.
A bottoms up basis, we're at like 190 and Q.
190.
Hello.
If everybody reset at the end of Q2, we would be at 190.
<unk>.
And then it goes up from there. So we kind of looked at it as an and I've kind of efforts to our asset sensitivity table.
In the in the queue.
You have to adjust for that incentive fee because that's just on a net.
Net investment income less interest cost basis, you have to adjust for the incentive fee.
But it is.
The book is about given the resets and worked through the floors.
The book is about the <unk>.
About the.
The take off.
Yes, okay.
That makes sense.
Appreciate you taking my questions I really appreciate.
The detail you gave in your shareholder letter.
Thank you thanks, Brian .
I'm showing no further questions in the queue I would now like to turn the call back over to Josh easterly for closing remarks.
Great. Thank you so much. Thank you for the questions. Thank you for the time for reading our 10 page letter.
12 page I hope you Didnt read the disclosures.
Yeah.
Although those are important as our borders will remind me.
We really appreciate it I hope everybody has a great rest of the summer and a labor day with their family.
And the war around in the fall and as I keep saying we're back in the office full time.
So please feel free to come visit and we look at getting back on the road and I think that now.
Things of where we are hopefully with a little bit post pandemic, as we're getting out and seeing shareholders and other stakeholders in portfolio companies and sponsors.
And so we're back out on the road and welcome people in our office.
Thank you so much thank you.
Thanks, everybody.
Ladies and gentlemen, this concludes today's conference call. Thank you for your participation you may now disconnect.
The conference will begin shortly to raise your hand during Q&A you can dial star one one.
[music].
Yes.
Okay.
Yes.
Okay.