Q3 2022 Sixth Street Specialty Lending Inc Earnings Call
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Good day and welcome to the fifth Street Specialty lending Inc. 2022 earnings Conference call. At this time, all participants are in a listen only mode.
After the speaker presentation, there will be a question and answer session.
To ask a question. During this session you will need to press star one one on your telephone you will then hear an automated message advising that your hand is right.
Please be advised that today's conference is being recorded I would now like to hand, the conference over to your speaker, Mr. Kamei Van Horne head of Investor Relations. Please go ahead.
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 fixed Street specialty lending Inc. Filings with the Securities and Exchange Commission. The company assumes no obligation to update any such forward looking statements yes.
Yesterday after the market closed we issued our earnings press release for the third quarter ended September 32022, and posted a presentation to the Investor resources section of our website Www Dot fixed street specialty lending dot com. The presentation should be reviewed in conjunction with our Form 10-Q filed yesterday with the SEC fixed rate specialties.
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 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 streets specialty lending Inc.
Good morning, everyone and thank you for joining US with me today is my partner and our President Bo Stanley and our CFO Ian Simmonds.
Call today I will review this quarter's results and then pass it over to Bo to discuss our origination activity and portfolio.
Ian will review, our quarterly financial results in more detail.
We will conclude with final remarks before opening up the call to Q&A.
After market closed yesterday, we reported third quarter financial results with adjusted net investment income per share of <unk> 47.
Corresponding to an annualized return on equity of 11, 5% and adjusted net income per share of <unk> 43.
Or an annualized return on equity of 10, 6%.
For the second consecutive quarter, our board has increased the quarterly basis.
I think we're having technical difficulties, let me try here please e-mail tammy.
If you can hear that we've got because we're having technical difficulties. So let me let me start again, thank you Cam and good morning, everyone and thank you for joining US with me today is my partner and our President Bo Stanley and our CFO , Ian Simmonds for our call today I will review this quarter's results and then pass over to Bo to discuss our origination activity and.
Yeah.
Ian will review, our quarterly financial results in more detail and I will conclude with final remarks before opening the call up for Q&A.
After market closed yesterday, we posted third quarter financial results with adjusted net investment income per share of 47 million corresponding to an annualized return on equity of 11, 5% and adjusted net income per share of <unk> 43.
For an annualized return on equity of 10 point pick for event for the second consecutive quarter. Our board has increased our quarterly based dividend wages figure by approximately seven 1% or <unk> <unk> per share to <unk> 45 per share to shareholders of record as of December 15th and payable on December 30.
By the way I hope people can hear me now.
This quarter's net investment income and a rise in our base dividend was driven by 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 Corey.
As we reported last quarter. The forward curve has steepened, resulting in core earnings in excess of what we previously anticipated.
Over the last five years, the rolling four quarter dividend coverage on a core earnings core earnings defined as.
Excluding all activity based.
Income averaged 102%.
At the new quarterly base dividend level of 45 cents per share we expect our core earnings exceed this level.
And highlights the significant influence that all in yield have had in our core earnings.
Generating ability for our portfolio.
<unk> enhanced levels of a different coverage.
That we anticipate extending through 2023.
And an understanding of our anticipated leverage the leverage levels, our board felt comfortable raising the quarterly dividend as.
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 that we have a high degree of confidence in meeting each period and maximizing the efficiency of our capital base.
While it based on the level of Q3 was well covered through core earnings no supplemental dividend was declared related to Q3 earnings given the NAV limiter and our distribution framework with Thursday to retain capital and stable at net asset value.
Revised level of our quarterly base dividend increases a quarterly book yield to 11% from our prior quarterly annualized book given the yield of 10, 3% our supplemental dividend framework remains in place, allowing for the opportunity to increase book given it yields with future supplemental dividends.
We are doing out there, earning summary, the <unk> per share difference between this quarter's net investment 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 is.
Bob will discuss the portfolio the performance of our portfolio has remained strong.
And our reported net asset value.
Per share from $16 27 to <unk> 36 was primarily driven by the accretive impact of issuing shares as have the majority of our 2022 convertible notes, which matured in August .
As you May recall recall from our conference call and the accompanying letter we published last quarter. Our valuation framework includes the impact of market spread movements into the valuation of our portfolio adjusting for the expected weighted average life.
And other idiosyncratic factors.
<unk> and low implied equity values. During this quarter resulted in approximately <unk> <unk> per share of unrealized losses, thereby partially offsetting the increase in net asset value. We experienced from the combination of accretion of the note's conversion and earnings above our base dividend level.
Turning now to a few thoughts in the current environment, we are seven months and into the rate hiking cycle.
The fed to increase rates 300 basis points year to date.
With the expectation of more to come.
<unk> being the most rapid rate increases backup into the 19th <unk>. It feels like we're in the mid innings as corporates and consumers to the three main sectors of the economy remain in a position of strength.
In our view the key the key to tame inflation will be real demand disruption, which we anticipate will be long, which will be a long battle for a number of important regions FERC overestimate stimulus during the pandemic, coupled with decades of low rates low inflation and increasing asset prices as a result, and strong corporate <unk>.
And consumer balance sheets, and access household savings for consumers.
Second while the interest rate increase while interest rate increases continue consumers have been somewhat insulated date.
Media impact as mortgages are fixed in nature, rather than floating rate or adjustable and wage growth has remained strong and environment of historically low unemployment.
This latter aspect has helped offset the effect of inflation on the levels of consumption.
Third given the feds ability to pivot is compromised by their need to tame inflation. It seems that the only way to create real demand destruction. It through a rise in unemployment, which likely begins once we see decline in nominal corporate earnings.
As quantitative tightening continue the monetary policy feed through with its usual lag than the impact of rising rates, where we felt differently across asset classes.
Risky assets will likely struggle in an environment, where the fact chief financial condition state.
Returns for long duration assets such as <unk>.
Tech and biotech equities.
A bit more meaningful meaningfully and negatively impacted by movement in rates as well move results 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 compromise of shorter duration assets and not sensitive to change in rates and less sensitive to widening of risk premiums given the ability to reprice.
Those assets every two to three years.
The benefit to our portfolio of 40% floating rate asset.
Floating rate short duration assets rising rate and spread environment is fundamentally dependent however, upon credit selection and accurate.
And active portfolio management we.
We believe these factors will ultimately be what drives the dispersion returns across effect overtime, given our track record through Covid 11 years investing through <unk> and 'twenty five years since our first direct with investment we feel well positioned to navigate the uncertainty uncertain macro environment and take advantage of the opportunity set that it presents.
With that I'll turn it over to Bo discussed this quarter's origination activity and portfolio.
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 underscores the value proposition of private credit for borrowers new issue leverage loan volumes were down 86% in Q3 relative to the same period last year and high yield bonds yield year to date reached its lowest level since 2000.
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 financing options available for borrowers were seeing a shift towards a more lender friendly environment not only are we seeing higher overall yields driven by higher base rates spreads have also widened as well during Q3 <unk>. The first lien and second lien spreads widened by 10 and 152 basis.
Respectively.
We're also seeing issue is 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 diamond 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 in a more lender friendly direction. There's 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 the debt obligations.
A very tight labor market similar to our approach during COVID-19.
Actively monitoring our portfolio 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 software and business services sector that provides mission critical products and solutions to their customers.
Moving to originations activity, we had $385 million of the commitments of $274 million of fundings across seven new investments six upsizing 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 to the back half of the year and this quarter's new funding along with our expectations for Q4 funding activities continue to support that view.
Several of our new investments in Q3 reflected the evolution, we're seeing on the direct lending market of larger financings as fewer borrowers are able to access traditional DSL market to meet their capital requirements.
In August reagent and closed a $375 million term loan commitment to support an operational turnaround by bed Bath and beyond.
As access to traditional sources castle has become more constrained our ability to invest alongside affiliated funds allowed us to be a valuable solutions provider for the company during a time of need.
Given the transactional complexity, we're able to drive better pricing and terms support which supports robust asset level yields.
Additionally, our expertise in the retail ABL space allows 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 <unk> beyond represents the 25th retail ABL transaction that we've completed with a total of $1 1 billion of capital deployed in <unk> through the strategy at quarter end, our retail ABL exposure increased to eight 4% of the portfolio on a fair value basis.
Also this quarter alongside affiliated funds, we agent and includes a $535 million senior secured credit facility to support Bain Capital's acquisition of lean cost.
Believe that bed Bath and lean cost 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 pieces and lean source was supported by an inherently sticky sticky underlying product and the software space, resulting in 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 comprises 78% of our portfolio on a fair value basis at quarter end, given our familiarity in less space in our balance sheet flexibility, we're able to provide a level of deal customization that sets us apart from our customer 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 realizations totaling approximately $16 million in Q3.
Full investment realization of Mississippi resources was related to the proceeds available from dissolving the business.
We received our final distribution distribution at the end of September and the remaining debt was repaid resulting in a small realized gain.
Since quarter end frontline and bio Haven, our two largest portfolio companies based on fair value as of 930 were repaid during the week.
The first week of October driven by previously announced M&A.
As of quarter end, our weighted average mark on bio Haven was 110, reflecting the impact of anticipated fees embedded in our underlying exposure to this portfolio company that have since been crystallized and <unk> 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.
Weighted average yield at amortized cost on new investments, including upsize of this quarter was 12, 6% compared to a yield of 10% on investments 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 onex and for Forex, respectively, and their weighted average interest coverage remained stable at two six times as of Q3 2022 the <unk>.
Average revenue and EBITDA of our core portfolio companies was $149 million $44 million respectively.
The performance rating of our portfolio continues to be strong with a weighted average rating of 112 on a scale of 1.1 to five with one being the strongest representing a positive change from last quarter's rating of 113.
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 nonaccrual during Q3.
Strength and improvement of these metrics quarter over quarter illustrates 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.
Thank you both for Q3, we generated adjusted net investment income per share of <unk> 47, and adjusted net income per share of <unk> 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 <unk> nine times to 1.15 times and our debt to equity ratio at September 30 was $1 one six times.
The increase was driven by portfolio growth from new investments during the quarter combined with minimal repayment activity.
As both previewed 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 position in bio Haven in frontline totaling approximately $146 million pro forma for these payment payoffs, which were the two largest positions in our portfolio at quarter end, we have close to $1 billion of liquidity.
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 is 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 quarterly earnings call to bring forward. The payment date of our quarterly base dividend to occur on the last business day of Dakota. The most recent base dividend payment date was September 30.
Hence the dividend that had previously been declared for Q3 dividend was paid to shareholders that will be the case in future periods as well.
During September our <unk>, one stock repurchase program was triggered resulting in repurchases of $3 million, which.
Which represents approximately 180000 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 both spoke about earlier our program trigger will be reset to activate at one penny below the most recent reported net asset value per share.
Moving to our presentation materials slide eight contains this quarters and Ivy bridge walking through the main drivers of NAV growth. We added 47 per share from adjusted net investment income against a base dividend of <unk> 42 cents per share. It was a positive <unk> <unk> per share impact from the conversion of the convertible notes that were.
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 <unk> <unk> 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 power amount of that investment in local currency through our multi currency revolving credit facility.
It 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.
And the schedule of investments depending on the movement of the relevant foreign currencies relative to the U S. Dollar. This can appear as though the valuation Mark has declined when the U S dollar strengthens however.
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 liabilities can therefore lead to an incorrect conclusion.
Use a specific example, let's look at our Canadian borrower in our schedule of investments, our Seo Solutions, Inc, where we hold a first lien term loan evaluation market quarter end is 101 spot zero at the end of Q2, the valuation Mark on our Seo was 101 spot two five from a credit perspective, they've been very limit.
That movement quarter on quarter.
Over that same period, however, the fair market value as a percentage of cost has fallen from 104 spot two to 97 spot five representing a significantly larger decrease in values and that represented by the limited decrease in the valuation Mark for Mr.
Mr. <unk> was the impact of the strengthening U S dollar over the period.
Taking into account our natural hedge created by borrowing in local currency the value of our Canadian dollar debt expressed in U S dollars.
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 four 6% of our portfolio. None of those investments are on non accrual status in each of the investments was rated one consistent with that of the overall portfolio that <unk> referenced earlier.
Now for our operating results detailed on slide nine 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 income interest and dividend income was $74 7 million up 26% from the prior quarter.
Fees, representing prepayment fees and accelerated amortization of upfront fees from unscheduled pay downs were lower at 429000 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 noncash reversal unwind 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, which increased our weighted average <unk>.
Interest rate on average debt outstanding from three 1% to four 3% and higher incentive fees as a result of this quarter's overwriting.
Before turning it back to Josh I'd like to briefly provide an update on our Aro ease. 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 net asset level yields cost of funds and financial leverage.
Today, we 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 yield and our expectations for fee related activity for the remainder of the year, including the <unk> 11 per share of fees that were crystallized in October from the payoff of bio Haven that we mentioned earlier, we believe we are on pace to exceed the top end.
With our previously stated target range for 2022 NII per share of $1 84 to $1 92.
This implies Q4 NII in excess of 54 cents per share and a full year early on adjusted net investment income of greater than 11, 5%.
With that I'd like to turn it back to Josh for concluding remarks, Thank you Ian.
As we all know periods of economic uncertainty present, both significant risks and significant opportunities on.
On the opportunity side.
These movements of volatility and market dislocation result in a shift of wave and the opportunity set from M&A tune opportunities have that requires private capital to be creative solution providers.
Our capabilities and expertise in the specialty specialty lending situations. We believe we absorbed an all cycle business model is well positioned to take advantage of this shift in the operating landscape.
We know that the best vintages are often underwrite underwritten in these times of uncertainty and we're ready to take advantage of the opportunities ahead.
Although I shared bearish views on the broader.
Macroeconomic backdrop I remain bullish in our ability to underwrite robust robust with adjusted asset level returns and generate strong consistent return.
ROE for our stakeholders over the last five years.
And a largely benign credit environment.
And the last five years, a largely benign credit environment still resulted in a wide dispersion of returns generated by managers in this sector, mostly driven by dispersion in credit costs. This is evidenced by the net realized losses of 100 150 basis points on an annualized basis in the sector based on clip wires directly.
The index over the trailing five year period through Q2, 2022 compared to net realized gains for <unk> for the same period.
We believe that this version will only expand as the operating backdrop becomes more complex as rates continue to rise and manager has been a lot of time talking about the impact from increased rates and asset sensitivity.
The rates will be beneficial to the sector in the near term long term outperformance is ultimately driven by the ability to avoid credit cost through the cycle. We believe we will continue to achieve this by following our same playbook that resulted in 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 Euro 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 line for questions.
Thank you as a reminder to ask a question you will need to press star one one on your telephone.
Ask that you please limit yourself to one question and one follow up question. You May then return to the queue. Please standby, while we compile the Q&A roster.
Our first question will comes from.
Jordan Watson or Finian O'shea with Wells Fargo.
Jordan I'll ask affirm today.
You mentioned lean Todd in your prepared remarks, we noticed that had a bigger chunk of laser raws versus funded this quarter and we've heard that <unk> kind of been harder to come by for borrowers. So I'm just curious on how you characterize that as a way for you and Pete on terms, you're picking up more economics for making that extension and the present.
Sure.
Any just any color you can add on that.
Okay. Thanks, Thanks, and toughen, Hello for Us and again sorry for the.
Yeah.
Technical difficulties this morning.
Idiosyncratic to lean task.
I think part of it was driven by competition.
In structuring consideration I think the general comment that delayed draw term loans or more difficult.
In this environment by most definitely true.
That transaction was earlier in the pipeline.
And quite frankly for us.
I think in this environment, we'd rather have we'd rather hold less unfunded.
Forward commitments and drive drive to fundings to drive economics in this environment. So I think that the author observation was true that deal was there were some idiosyncratic considerations that it was much earlier in the pipeline and the environment.
Okay and then.
Just more generally on the market. We just saw with Emricasan deal that it kind of more closely match the old School Bank first lien in private.
Private credit kind of takes a backseat behind the banks so for you guys.
Okay.
This is the wrong assumption is just just I.
The Emerson term loan a and term loan b are parry pursue and so there is no back seat.
The bank.
Yeah.
I think that was a a.
<unk> conclusion.
It's not a silo, it's not a first lien second lien.
Parry pursue capital where the banks are holding on balance sheet.
And basically the only difference is amortization, but it's fair to assume the capital structure with a term loan b, having much higher spread for the <unk>.
Credit markets and so I think Blackstone was figure out of the way.
Effectively use their their relationships with banks to where they can figure out how big could have given them. Some amortization have a piece of paper that worked form.
Environment given returns on capital and then the marginal capital from the private credit private credit market, which was pay pursue price much wider so I think.
That assumption is a false assumption, which is Bob back to you to start a follow if all perry for through that.
That's good to hear thanks for clarifying that and that's it for me today.
Thank you and one moment for our next question.
And that will come from the line of Kevin <unk> with JMP Securities. Please go ahead.
Hi, Good morning, Thank you for taking my question.
<unk> touched on this a bit in his prepared remarks, but I just wanted 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 am curious if you could talk about how that's translated to deal pricing library to improved documentation and build the originating right now compared to six to 12 months ago.
Yes look I'll, let Paul handle let me hit on Emerson's I think Emerson is a great example of that.
Mike not to get into details like it did in the general direction.
That that term loan b on Emerson My guess would have been.
In a broadly syndicated market it is a unbelievably.
Well good credit.
And with a good capital structure. It probably would have had two to two and a half turn wider of first lien debt and would have been priced to.
300 basis points tighter compared to the term loan b and so just on Emerson you had.
That first lien will had.
<unk> plus two to two five turns less.
Sure.
That with significantly wider pricing.
That to me is a.
A really good example.
Really tightening underwriting standards and wider spread and again the marginal capital and that deal was the was.
The private credit market, which really drove.
No return.
In this market. So I don't know if you have anything that 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.
Anywhere in the range from 100 to 200 basis points plus from what we saw for comparable comparable businesses. Just six to 12 months ago Youre seeing also a turn to two turns 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 under the market.
Okay. That's really helpful color and then just one more if I can.
You are relatively active again this quarter investing in CLO note.
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 youre seeing investing in CLO, how much capital you are willing to put to work there and if you view these investments as buy and hold they're more short term in nature.
We've always used it as a yes.
We're not traders we've always used it as a rollout barometer for relative value. We still think there is really strong relative value given the loss taken ability and CLO, which imply the lose money. We're investing in those securities you have to have like one five to two times Kim default that you saw in the <unk>.
Financial crisis.
And there are <unk> securities that yield.
Yields similar to when you think about with the discount similar to private credit. So we think theres a great relative value.
Investment in.
And again, it's a relatively small part of our portfolio.
A relatively small part of our portfolio.
Okay I'll leave it there congratulations on the quarter.
Thanks.
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.
Hi, good morning, Thanks for taking my question.
And 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 youre seeing in terms of any kind of amendment activity in the most recent quarter. Thanks.
Yeah, it's Joshua.
The great thing about private credit as you get that dialogue, we had no material amendment activity this quarter.
And so it's been it was a really really benign the portfolio is in really really good shape. It is a very.
Very very benign.
Uh huh.
Levels of activity on amendments and waivers.
I think that speaks to the portfolio.
And our quality portfolio, which we built which mostly when you think about the nature of our business I think like 70% to 80%.
<unk> has been.
Of the existing portfolio relates to software and business services that have recurring revenue variable cost structures and so it was a again no material.
<unk> waivers this quarter.
Got you very helpful.
And just one follow up if I may in terms of the debt Paydowns.
You saw a slowdown in the quarter.
Matt and you said it just the environment.
Giving that what.
In your view, what could potentially drive a potential pickup in terms of pay down activity at some point or would you expect.
Relatively dampened activity just in the near term given the macro backdrop. Thanks.
Thanks, Ken.
Let me answer your question I think this is a really important thing for people who understand.
Look.
Pay downs typically drive activity based income and that tends to be lumpy over the over that over the year quarter per quarter. We had two large paydowns at the end of the quarter as he tried to beginning of Q4, which was literally I think October one.
I'll cover three and four but right the first week of October .
By leaving that will drive about that will drive about <unk> 11 per share of activity based income in the Q4 is that by the way that could have happened in Q3. So it's really it's really hard to tell when that happens.
But it is most definitely been a benign not shockingly a benign year for portfolio turnover, given the widening credit spread environment and so what you would typically see as in a widening a tighter credit spreads are tightening credit spread environment or a environment, where you have looser underwriting standards.
Which I think means lower volatility and lower macro volatility that you will see that portfolio churn.
Okay.
Uh huh.
The last point I would make is the.
Historically, we've earn somewhere between 98, 105%.
And coverage from core earnings when we define core earnings I think that's different than what other people do in the industry like Gary what we defined as just really interest income.
Interest income from Red willingly amortization of all I E.
And thats been 90% to 102% coverage on our dividend our dividend I think in the new with the increase raised our dividend by 7%.
Our coverage is actually greater than our historical environment from core just pure interest income.
So I think an environment where activity levels pick up we will have we're pretty well situated well situated given where our balance sheet leverages to continue to drive.
Interest income.
Wealth fees are our new dividend plus will have income from anchor.
Income from activity levels, but thats going to happen in an environment, where you have.
Hi, James Brad's looser underwriting standards, and then I think.
Specific to us given some of our business is more special situations, especially Olympian oriented.
That part of the portfolio constantly churns no matter what environment yearend. So hopefully that was a long winded way to answer to your question, but I wanted to use the opportunity to give you. The full picture of the earnings the increased earnings power of the business and what really drives income.
And return on equity for the business.
No that was great that was great color, there and really appreciate.
The answer there thanks again.
Thank you one moment for our next question.
And that will come from the line of Melissa Wedel from Jpmorgan. Please go ahead.
Good morning, I appreciate you taking my questions today.
Curious to get your thoughts on.
Just sort of that supply side.
And private credit you talked about the increase in demand.
Private credit solutions.
Ireland.
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 amongst peers for that.
Yeah. So.
Hello.
The way I would frame it is.
And it's pretty clear that check sizes.
Have come significantly down.
Four.
Some large investment from large private creditors.
Large private credit or credit investors in this space.
So you once all.
People, writing 500, the $2 billion chassis that are writing.
<unk> significantly less today, and so I would say the.
We live in a market where.
On a go forward basis with the demand for credit will be somewhat less and that opportunity set is changing so it's changing from M&A and buyout and recaps two barrels we still some of that but really.
Kind of our core specialty lending aspect and the supply of private credit is also coming significantly down and so you have seen wider spreads and tightened underwriting standards and so I think there is.
The economy shrinks or stagnated, a little bit the demand for credit wharf obviously.
But you're also seeing the supply shrink and you've seen that.
If you think about the equilibrium of that you've seen that in widening spreads and tightening underwriting standards and so I think that's a function of mostly the supply side and because of the demand side M&A is down the demand side shrinking as well so hopefully that answers it.
No that does that's helpful. I appreciate that and if we could pivot for a moment Q sort of your ABL strategy I know you touched on one investment that you made during the third quarter.
Lee.
Sort of a follow on from.
Investments that you've made in the past.
Think back to when you last were really involved.
Liam policy in originating ABL.
Investments.
With a bit of a different environment and a lot of ways, but particularly with regard to inflation I'm curious if.
You have to evolve your underwriting or how you approach the ABL and a higher inflationary environment, yes.
It's a great question, so a little history on our ABL look we this is a business we know very very well.
Physically on bed Bath and beyond I think that speaks volumes about our platform which was.
And and then sharp is that material in our P&L, but we originated that investment and sold it above our cost increase syndication income.
For <unk> this quarter so.
Our ability to deliver the entire platform.
To deliver in size to an issue or with certainty allowed us to create additional economics and something that was worth more than cop for our investors.
I think people should understand that.
<unk>, most definitely changed the great thing about.
Those type of structures and loans is that when we get to evaluate the value of our collateral.
Environment.
And the environment that we're in today, where.
If there is margin compression the value of that inventory goes down and so.
Which means what we win go than what we actually land on that collateral dose down and so it's a pretty dynamic way to approach the market and again, we've been in this market for 20 plus years and we've invested across the cycles and you most definitely have to be macro away.
That being said there is a mechanism and how we structure. These deals and how we think about it which allows us to adjust our risk dynamically.
Is that fair, Mike, Yes, no I agree.
And the good news is I think that opportunity definitely getting bigger which is <unk>.
Post Covid when you think about the world consumers had a lot of dollars in their pocket.
I couldnt spend money on on on activities are a vacation.
They bought goods.
Which created a environment, where retailers had really really good balance sheets high gross margin high EBITDA margins and that's kind of reversing and so I think our capital in this environment will be very very valuable.
Thanks, Josh.
Thank you as a reminder, if you have a question. Please press star one one.
Our next question.
That will come from the line of Robert Dodd with Raymond James. Please go ahead.
Hi.
So you partially answered this and this helps them also.
When we look at the portfolio.
Earlier comment.
The mix of the structure of loans going forward I mean, do you expect highly structured loans be ABL, what that's like more special situations.
Do you expect that to be a growing portion of the portfolio over the next call. It 18 months 24 months whatever it is how long how long this rate cycle guys.
Given in incomes is obviously.
Or more.
Quite so on conventional loan.
Amazon has got better language, it's got better yield.
Quite a spread.
Structurally I think it would be classified as a more conventional.
<unk>.
That debt.
The attractiveness of those normal loans with higher yields.
To be competitive with some of the special situations kind of things that you do or how do you think that mix in the portfolio is going to look over the next couple of years.
If you look at a lot of excess.
He comes from Bose activity fees, all special sits kind of that kind of thing.
Yeah look I think post Covid, where the world was flushed with liquidity.
And corporates and retail again had really good balance sheets, they didnt need our capital and that's been historically, a 20% growth on Levered return for us and so when you think about the total return for that business. So.
And I agree with you a lot of our access has come from those type of businesses.
Type of special situations like Farrell gas.
The retail ABL stuff.
<unk> metallic go or not.
A lot of those so I expect it actually to massively increase in this environment going forward.
As credit availability dries up.
And there is demand destruction and core and corporate tab.
Corporate balance sheets are getting a much more difficult position I think theres going to be a lot of opportunity, where we can bring the expertise of our platform. Both are in the industry and product standpoint, the VA solution provider that will drive excess returns for <unk> shareholders.
That I think is.
The single most valuable thing about our business, which is we get to invest across cycles and take high relative value.
From a risk adjusted return perspective, and our shareholders benefit from that and so most definitely I think it's going to increase historically.
About 40% of our originations, but it's been a much smaller part of our portfolio because that portfolio churns quicker.
Think that theres going to be most definitely a shift.
But egg requires.
A different type of platform.
<unk>, which is a platform that is our platform. This environment. So far platform, which is we are able to navigate comeback complexity.
Create good risk adjusted returns for our stakeholders in a way where other platforms are set up just to do sponsor business.
And our long the M&A environment are unable to do so this is I couldnt be more excited about the opportunity set going forward and by the way we'll do both.
But we have the opportunity to pick the highest risk adjusted returns and.
And drive return on equity for for our shareholders because that top of our funnel is much broader and so we have a broader view of the world.
Your most definitely we're onto something Robert.
Okay I appreciate that follow up to that if I can real quick.
You have that expertise on the platform have you seen any increase in.
Poaching efforts is that given given the market gets more troubled and you have.
Okay.
A portion of your capital and.
<unk> expertise in some of these others.
Even attempt to poach modules that how are you.
<unk>.
It is not happening again I have to give a little bit if that has happened can you give us any any color.
Look I, we havent in what I would say is is that.
I think it culturally takes a different mindset.
There are I'm not going to go platform by platform a name by name.
Nick.
There is a court.
There is a cultural.
A cultural difference because on the where you have complexity requires.
Private equity style due diligence real deep negotiation on docs, a real hand to hand combat and quite frankly.
I would say is less profitable to the GP in this is that it takes more people and more time.
And you don't get to keep an asset.
Along and so I think there was like economic.
People make economic choices, we tried to make that choice choices just yet.
Line of our shareholders and stakeholders.
And I think that there are cultural issues.
As it relates to like getting into this business.
Because it's not like a sponsor is giving you a cap structure and a and AA and all their due diligence.
It's a really different business, so we haven't seen it.
This is again, one thing I love about our platform that we built as I felt like we can be ranging across cycles.
Really create value and I would say there are some platforms that can do it but a lot of the traditional sponsor based platforms theyre not built culturally to do this they made a different economic choices and so we haven't we haven't seen them.
I appreciate that thank you.
Thank you one moment for our next question.
That will come from the line of Ryan Lynch with <unk>. Please go ahead.
Hey, good morning.
The question that I had is just related to your interest coverage and your software portfolio as I kind of think about.
Historically as I think about kind of software investments.
I typically think because they're more resilient businesses for an economic downturn. They typically have higher purchase price multiples and corresponding higher leverage levels, though that that come with those investments. Obviously, you may disagree with that but if that assumption is correct.
How should we think about and how are you guys viewing.
<unk> coverage and the ability for those borrowers to withstand.
Higher interest rates from basically zero to 4% to 5% likely next year. If some of those businesses Wow I think are structurally a stronger business has been more resilient businesses might have more leverage.
Then maybe an average.
Company.
Yes, great Great question.
I'm not sure they have in our portfolio that much more leverage but some of your premise is correct.
First of all interest coverage of our portfolio I think is flat quarter over quarter on LTM basis on LTM basis. So we haven't seen degroot degradation in interest coverage, which means that management teams are able to.
Push through pricing.
Or change cost structures.
And the great thing about software businesses that tend to be 80% to 85% gross margin businesses and have variable cost structures beneath that.
So they and their revenues are typically known so when you when we look at the health of our software portfolio just to go through because I think it is helpful.
And we try to look at Kpis or that more forward leaning about the health of the business.
So just to give you a couple of statistics revenue grew quarter over quarter.
About.
6% quarter over quarter.
And year over year about 17% and then when you look at retention in that business and retention is a really big driver of forward revenue.
Retention in Q2 was 90% growth that was before upsells et cetera, and 105% net and that pretty much that same range, 91% growth in 103% to 104% net in Q2 and so the fun.
Minerals of our software business interest coverages remain pretty there's been same quarter recover quarter and the fundamentals in the software business has been really really good and when you think about the great thing about that business as they are literally when you look at the customer base on a same store basis their customer base is growing.
They don't have to do anything between people buy new products and pricing and so I feel really good about how we're positioned and it shows up both we both on a four perspective when you look at the Kpis of the business that afford indicators and entrants coverage, which isn't a historical.
As shows up there as well so I like that defensive nature of how we are positioned.
Currently.
And I think it's showing through in the fundamentals of the book Bo do you have anything to add on that.
That said it also as I mentioned in the.
The earnings call art or detached points have remained stable at four point Forex.
That's across the all borrowers, but we feel very good about the health of that software portfolio and the core earnings power.
That's helpful and I really do appreciate the.
The specific statistics that you provided on on hub software.
Portfolio is performing.
Can you provide the overall intra.
Interest coverage I know you said that didn't change.
In the trailing 12 months this quarter, but what is the overall interest coverage to hit your portfolio two things too.
Two six.
Okay Alright.
Pretty it's pretty healthy okay. That's all for me I appreciate the time today.
Thanks.
Thank you and speakers I'm showing no further questions in the queue. At this time I will turn the call back over to management for any closing remarks.
Great. Thank you again for the tech.
The technical difficulties earlier.
I appreciate you hanging in for those 30 seconds it seemed like a lifetime.
I hope everybody has a happy Thanksgiving.
And our holiday season.
We will continue to work very very hard we think the environment is really interesting.
For for our skill sets and capital type of capital one.
We look forward to chatting.
In the future. Thanks, thanks, everyone.
Goodbye. This concludes today's conference call. Thank you for participating you may now disconnect.
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