Sixth Street Specialty Lending Q1 2024 Earnings Call Transcript

Quartr
Provided by Quartr
May 2, 2024

There are 13 speakers on the call.

Operator

Please be advised that today's conference is being recorded. I would now like to hand the conference over to your speaker, Cammy Van Horn, Head of Investor Relations. Please go ahead.

Speaker 1

Thank you. Before we begin today's call, I would like remind our listeners that remarks made during the call may contain forward looking statements. Statements other than statements of historical facts made during this call may constitute forward looking statements and are not guarantees of future performance or results and involve a number of risks and uncertainties. Actual results may differ materially from those in the forward looking statements as a result of a number of factors, including those described from time to time in Sixth Street Specialty Lending, Inc. Filings with the Securities and Exchange Commission.

Speaker 1

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 Q1 ended March 31, 2024 and posted a presentation to the Investor Resources section of our website, www.6thstreetspecialtylending.com. The presentation should be reviewed in conjunction with our Form 10 Q filed yesterday with the SEC. Sixth Street Specialty Lending, Inc. Earnings release is also available on our website under the Investor Resources section.

Speaker 1

Unless noted otherwise, all performance figures mentioned in today's prepared remarks are as of and for the Q1 ended March 31, 2024. As a reminder, this call is being recorded for replay purposes. I will now turn the call over to Joshua Easterly, Chief Executive Officer of Sixth Street Specialty Lending, Inc.

Speaker 2

Good morning, everyone, and thank you for joining us. With us today are our President, Bo Stanley and our CFO, Ian Simmons. For our call today, I will review our Q1 highlights and pass it over to Beau to discuss activity and the portfolio. Ian will review our financial performance in more detail and I will conclude with final remarks before opening the call to Q and A. After the market closed yesterday, we reported 1st quarter adjusted net investment income of $0.58 per share or an annualized return on equity of 13.6 percent and adjusted net income of $0.52 per share or an annualized return on equity of 12.3%.

Speaker 2

As presented in our financial statements, our Q1 net investment income and net income per share inclusive of the unwind of the non cash accrued capital gain incentive fee expense were $0.01 per share higher. The difference between this quarter's net investment income and net income was driven by $0.09 per share of net unrealized gains from the impact of tighter credit spreads on the valuation of our investments, dollars 0.14 per share on net unrealized losses from portfolio company specific events and $0.03 per share of unrealized losses from the reversal of prior period unrealized gains related to investment realizations and $0.03 per share of realized gains from investment sales. With these results in mind, I'd like to start by circling back to 2 remarks I made on previous earnings calls in February. First, the BDC sector is at peak earnings and second, the tail within portfolios is getting longer. On the first comment, we reported another strong quarter from an earnings perspective as net investment income continued to benefit from higher interest rates.

Speaker 2

Q1 was the first time in 8 quarters or since the start of the rate hiking cycle that we experienced a modest decline in the weighted average reference rate resets on our debt and income producing securities of 5 basis points. That said, the strength of the recent economic data in the higher for longer shape of the forward interest rate curve continues to support net investment income. Since our last earnings call, the forward curve has shifted towards higher for longer with year end base rates estimated to be 4.9%, which is up from 4.2% as of our last earnings call in February. We anticipate the current environment will likely drive a dispersion between operating and GAAP earnings as higher base interest rates may ultimately lead to credit deterioration and potential for losses as we previously talked about. On my second comment, we're adding a nuance to the view that this quarter, which is that the tail is growing on the margin.

Speaker 2

While we are seeing evidence of idiosyncratic credit issues arising from across the private credit sector, we remain optimistic about the ability for private credit portfolios to withstand the headwinds of today's macroeconomic environment for a couple of reasons. 1st and foremost, private credit managers underwrite investments with intent of holding that risk until maturity given the largely illiquid nature of the asset class. For us, this means extremely thorough due diligence and bottoms up analysis on every credit we undertake coupled with active portfolio management through the life of the investment. And second, private credit managers have the ability to be selective in terms of sector exposure. We have demonstrated selectivity in our portfolio by avoiding cyclical businesses, staying away from certain industries and leaning into specific sector themes.

Speaker 2

This optionality differs from the public debt market, which are forced to hold a much broader range of sector exposures, including those that we have deliberately avoided. It is important to note that both of these benefits to private credit are not given and ultimately rely upon active management. Having the ability to determine when to invest as well to what to invest is a feature of our business model and a core principle of operating our business with capital allocation discipline. Turning to our portfolio specifically. The difference between this quarter's net investment income and net income highlights our point on the growing tail.

Speaker 2

Individual portfolio company specific events resulted in a $0.14 per share net unrealized losses in Q1. A significant portion of or $0.11 per share was related to the markdown in our investment in Astra Acquisition Corp. At quarter end, we added this investment to non accrual status, driven by continued underperformance of the company. While this is evidence that the tail is growing on the margin, we remain focused on the bigger picture, which is our ability to grow net asset value over the long term. Despite idiosyncratic issues as existed in our portfolio, we have steadily and consistently grown net asset value over the 12.5 years since we started this business, represented by 3.5% annualized NAV growth before special and supplemental dividends since inception.

Speaker 2

We feel confident in our ability to continue this growth in the future, which we believe will result in our performance relative to the sector. Turning now to the broader portfolio. Credit quality remains strong with non accruals limited 1.1% of the portfolio by fair value. Revenue and EBITDA growth continued for another consecutive quarter. Several of our portfolio companies have started to see cost saving initiatives flow through the P and L resulting in margin expansion and positive EBITDA trends.

Speaker 2

All things considered, our underlying portfolio companies have shown resilience, which we believe is reflective of our disciplined credit selection and effective portfolio management. Yesterday, our board approved a base quarterly dividend of $0.46 per share to record to shareholders of record as of June 14, payable on June 28. Our Board also declared a supplemental dividend of $0.06 per share related to our Q1 earnings to shareholders of record as of May 31, payable on June 20. Our net asset value per share pro form a for the impact of the supplemental dividend that was declared yesterday at $17.11 and we estimate that our spillover income per share is approximately $1.06 Before passing it to Bo, I would like to note that on March 26, Fitch Ratings Agency published their annual review for the BDC sector and we are pleased to note that 6 REIT Specialty Lending's rating of BBB Flat was revised with from a stable to a positive outlook. Of the 22 firms in their rated universe, TSLF is one of 2 BDCs to hold a rating with a positive outlook from Fitch.

Speaker 2

With that, I'll now pass over to Bo to discuss this quarter's investment activity.

Speaker 3

Thanks, Josh. I'd like to start by sharing some observations on the broader market backdrop, in particular, the purpose and importance of direct lending in today's investing landscape. Through the Q1 of 2024, public and private debt markets welcomed an increase in demand for financing solutions after a historically low level of transaction volume in 2023. Access to the broadly syndicated market has improved providing some borrowers with an option between public and private financing solutions. With both markets open for business, competition has generally increased compared to this time last year.

Speaker 3

However, we remain highly selective in where we transact to make certain we over earn our cost of capital. Our omni channel sourcing capabilities has contributed to a robust and building pipeline of opportunities that rely upon the structures and features available only in the private credit markets. We believe the current environment underscores the value proposition of private credit for borrowers looking for more than the cheapest cost of financing. Direct lending provides creative solutions, certainty in pricing, stability through market volatility and structural flexibility such as delayed draw features. All of these components differentiates the private credit markets from the BSL market and reinforce the importance of solutions we provide to the middle market companies.

Speaker 3

Our investments in Equinox during the quarter highlights our differentiated capabilities as we stepped in to provide an alternative solution to a company with a complicated capital structure. As part of the transaction, 6th Street led an agent at a $1,200,000,000 first lien term loan and to a lesser degree participated in a $575,000,000 second lien term loan. SLX committed $47,900,000 $2,100,000 in these loans respectively in support of the company's refinancing of existing debt. This investment is also representative of the increase in opportunities we are seeing for companies with durable business models looking to restructure their balance sheets. In most cases, the complexity of these transactions require a direct lender that is willing and able to structure and underwrite a creative solution.

Speaker 3

Given our extensive experience and dedicated resources across the 6threet platform, we are well positioned to lead these opportunities. Additionally, the level of competition is lower for these investments compared to more traditional loan structures, which has contributed to our busy start to the year from an perspective, which I'll pivot to now. In Q1, we provided total commitments of $264,000,000 and total fundings of $163,000,000 across 9 new portfolio companies and upsizes to 5 existing investments. We experienced $109,000,000 of repayments from 3 full, 7 partial and 18 structured credit investment realizations resulting in $54,000,000 of net funding activity. There was another strong quarter for originations with 95% of total fundings in new investments with 5% supporting upsides into existing portfolio companies.

Speaker 3

This quarter's funding has contributed to our diversified exposure to select industries with 9 new investments across 8 different industries. Consistent with our long term approach of investing at the top of the capital structure, 95% of fundings this quarter were in 1st lien loans, bringing our total 1st lien exposure to 92% across the entire portfolio. We continue to benefit from the size and scale of Six3's capital base as we participated in several cross platform deals, including our largest new commitment during the quarter, which supported the take private transaction of Alteryx. In March, 6th Street aged and enclosed on a senior secured credit facility as part of the $4,400,000,000 acquisition of Alteryx by Clear Lake Capital and Insight Partners. Our close relationship with both sponsors combined with our ability to commit to the deal and size were key to securing our leading role in the debt financing.

Speaker 3

Moving on to repayment activity, our 2 largest exits during the quarter, Assayo and Bill Highway were older vintage assets that were driven by refinancings. These investments generated a weighted average asset level gross IRR of 12.2% for SLX shareholders. Beyond refinancings, another notable area of repayment activity during the quarter was in our structured credit portfolio. As a reminder, we purchased approximately $54,000,000 of CLO liabilities at a significant discount to par during the market volatility that occurred in Q2 and Q3 of 2022. Rather than holding excess capital or deploying capital into investments that do not exceed our cost of capital, we leveraged the experience across the 6REIT platform to opportunistically invest in BBB and BBB CLO liabilities that presented an efficient use of shareholder capital.

Speaker 3

Since then, we have watched our investment thesis play out as we rotated out of approximately 85 percent of our CL level liability exposure today. We purchased those securities at a weighted average price of 88.5 with a 3 year discount margin of approximately $8.80 and exited at a weighted average of 98.5 with a 3 year discount margin of approximately 5.35 For Q1, these exits resulted in approximately $0.02 per share of realized gains for SLX shareholders. We expect to continue rotating out of the structured credit portfolio to crystallize the returns we've generated and will opportunistically come back to this theme in moments where it presents an efficient use of capital based on the return profile. From a portfolio yield perspective, our weighted average yield on debt and income producing securities at interest cost decreased slightly quarter over quarter from 14.2% to 14.0%. This decline reflects the combination of 10 basis points of spread compression from lower spreads on new investments and 5 basis points from the decline in reference rate resets.

Speaker 3

New investment spreads were lower in Q1, largely driven by roughly 2 thirds of our fundings, including an upside of this falling into what we call our Lane 1 bucket. Lane 1 has extraordinarily been about 65% of our total investment activity and generally includes regular way financings to sponsor back companies. In Q1, this includes investments in high quality companies such as Alteryx and Clearance Technologies, which are scaled businesses with attractive financial profiles. The other third of our funding activity was in more complex lane 2 buckets, which typically includes higher yielding assets represented by our investment in Equinox during the quarter. As an illustration of the difference in yields, our new Q1 investments in Lane 1 had a weighted average yield and amortized cost of 11.3% compared to 14.0% for our investments in Lane II assets.

Speaker 3

On a consolidated basis, the weighted average yield of amortized cost of new investments including upsizes for Q1 was 12.2% compared to a yield of 14% on fully exited investments. Moving on to the portfolio composition and credit stats, across our core borrowers for whom these metrics are relevant, we continue to have conservative weighted average attach and detach points of 0.7 times and 4.9 times respectively. And our weighted average interest coverage remains constant at 2.0x. As a reminder, interest coverage assumes we apply reference rates at the end of the quarter to steady state borrower EBITDA. As of Q1 2020 4, the weighted average revenue and EBITDA of our core portfolio companies was $275,500,000 92,500,000 respectively.

Speaker 3

Finally, the performance rating of our portfolio continues to be strong with a weighted average rating of 1.15 on a scale of 1 to 5, with 1 being the strongest, representing improvement from last quarter's rating of 1.16 driven by growth in the portfolio from new investments. As Josh mentioned earlier, we added 1 new company, Astra Acquisition Corp, to non accrual status at the end of the quarter, resulting in 2 portfolio companies on non accrual across the entire portfolio. With that, I'd like to turn it over to my partner, Ian, cover our financial performance in more detail.

Speaker 4

Thank you, Beau. For Q1, we generated adjusted net investment income per share of $0.58 and adjusted net income per share of $0.52 Total investments were $3,400,000,000 up 3% from the prior quarter as a result of net funding activity. Total principal debt outstanding at quarter end was $1,900,000,000 and net assets were $1,600,000,000 or $17.17 per share prior to the impact of the supplemental dividend that was declared yesterday. Since the start of the rate hiking cycle 2 years ago, we have successfully grown net asset value per share by 5.6% from a trough of $16.27 in Q2 of 2022 to $17.17 as of quarter end. Additionally, net asset value per share is now back above the pre rate hike level of $16.88 as of March 31, 2022 and is a $0.01 below our historical high of $17.18 It has been a very busy year start to the year as we completed several capital markets transactions, including a bond offering, an equity raise and a revolving credit facility extension.

Speaker 4

Starting off in early January, we improved our funding mix and liquidity profile through a $350,000,000 long 5 year bond offering. In March, we executed a small equity raise to take advantage of attractive new investment opportunities, while remaining below the top end of our target leverage range of 1.25 times debt to equity. Consistent with the framework we've outlined in the past, we issued equity above net asset value and deployed the new capital raised into assets generating estimated returns that exceed our calculated cost of capital. We'll spend a moment to walk through this math, starting with the assumption that our cost of equity is 9%, which was sourced from Bloomberg. Based on this assumption, we can back into the required return on new assets by applying the cost structure of our business, including the marginal cost of leverage, fees, estimated credit losses and other expenses to our unit economics model.

Speaker 4

This calculation results in a 10.6 percent return on assets inclusive of credit losses required to generate a 9% return on equity. In our case, we deployed the new equity capital into investments with an average asset level yield of 12% to 13.5% depending on the assumed weighted average life, resulting in an estimated ROE range of approximately 11.5% to 14% for the capital deployed, well above our estimated equity cost of capital. Shareholder returns continue to be our priority and we strongly believe that our ability to access additional equity capital allows us to generate attractive risk adjusted returns for our investors. Post quarter end, we further enhanced our debt maturity profile by closing an amendment to our revolving credit facility. With the ongoing support of our bank group, we amended our $1,700,000,000 secured credit facility, including extending the final maturity on $1,500,000,000 of these commitments through April 2029.

Speaker 4

We are pleased with this outcome of this transaction as we successfully converted a legacy non extending lender to extending status and accepted an incremental commitment from an existing lender. There were no new non extending lenders as part of this amendment, and we maintained the existing pricing and terms on the facility. The combination of the January bond issuance and the closing of the amendment to our credit facility extended the weighted average maturity on our liabilities to 4 years, which compares to an average remaining life of investments funded by debt of approximately 2.5 years. This element is important to our asset liability matching principle of maintaining a weighted average duration on our liabilities that meaningfully exceeds the weighted average life of our assets funded by debt. All three of our capital markets transactions bolstered our balance sheet by enhancing our liquidity profile.

Speaker 4

As of March 31, we had $1,100,000,000 of unfunded revolver capacity against $260,000,000 of unfunded portfolio company commitments eligible to be drawn. In terms of capital positioning, our ending debt to equity ratio from the balance sheet decreased quarter over quarter from 1.19x to 1.14x. The decrease was driven by the equity raise in February combined with repayment activity, which was partially offset by portfolio growth from new investments. As for upcoming maturities, we have reserved for the $347,500,000 of 20.24 notes due in November under our revolving credit facility. After adjusting our unfunded revolver capacity as of quarter end for the repayment of the 2024 notes, We continue to have ample liquidity of $764,000,000 representing 2.9 times the amount of our unfunded commitments eligible to be drawn.

Speaker 4

Additionally, the repayment of 2024 notes will have an economic impact in 2025 as the implied funding mix shift will lower our weighted average cost of debt. Pivoting to our presentation materials, Slide 8 contains this quarter's NAV bridge. In addition to the items Josh walked through earlier, the equity raise resulted in $0.14 per share uplift to NAV in Q1. Moving on to our operating results detail on Slide 9, we generated $117,800,000 of total investment income for the quarter, down 1.5% compared to $119,500,000 in the prior quarter. Interest and dividend income was $112,100,000 down slightly from the prior quarter driven by the marginal decline in interest rates off of peak levels experienced in Q4.

Speaker 4

Other fees representing prepayment fees and accelerated amortization of upfront fees from unscheduled paydowns were lower at $1,500,000 compared to $3,500,000 in Q4 driven by lower coal protection from payoffs of older vintage assets during the quarter. Other income was $4,300,000 compared to $3,900,000 in the prior quarter. Net expenses excluding the impact of the non cash reversal related to unwind of capital gains incentive fees were $65,400,000 up slightly from $65,000,000 in the prior quarter. Our weighted average interest rate on average debt outstanding decreased from 7.8% to 7.6% driven by the marginal decline in reference rates. Before passing it back to Josh, I wanted to circle back to our ROE metrics.

Speaker 4

In Q1, we generated an annualized ROE based on adjusted net investment income of 13.6% and an annualized ROE based on adjusted net income of 12.3%. This compares to our target return on equity on net investment income of 13.4% to 14.2% for the full year as articulated during our Q4 earnings call and we maintain this outlook heading into the rest of 2024. With that, I'll turn it back to Josh for concluding remarks.

Speaker 2

Thank you, Wayne. I'd like to close our prepared remarks here by encouraging our shareholders to participate in both for upcoming annual and special meetings on May 23. Consistent with previous years, we're seeking shareholder approval to issue shares below net asset value effective for the upcoming 12 months. To be clear, to date we have never issued shares below net asset value under prior shareholder authorization granted to us for each of the past 7 years. We have no current plan to do so.

Speaker 2

We merely view this authorization as an important tool for value creation and financial flexibility and periods of market volatility. As evidenced by the last 10 plus years since our initial public offering, our bar for raising equity is high. We've only raised equity when trading above net asset value on a very disciplined basis. So we would only exercise this authorization issue shares below net asset value as there are sufficiently high risk adjusted return opportunities that would ultimately be accretive to our shareholders through over our cost of capital and any associated dilution. If anyone has questions on this topic, please don't hesitate to reach out to us.

Speaker 2

We have also provided a presentation, which walks through this analysis in the Investor Resources section of our website. We hope you find the supplemental information helpful as a way of providing a clear rationale for providing the company this access to this important tool. As a final comment for today's call, I wanted to share my thoughts on the recent press focused on the perceived systemic risk in private credit. I would suspect that this narrative largely comes from participants that have lost market share and the associated fee streams from the growth of private credit. Clearly, private credit has been a disruptive force to the incumbent business model in the non investment grade corporate credit space, which has banks acting as an intermediary, which we have called the moving business, sitting between issuers and ultimate holders of risk and collecting an economic rent.

Speaker 2

Private credit is no doubt disruptive to this model. The criticism of private credit is that it's taking more risk on the asset side. However, the historical data doesn't support this argument. According to Cutwater's direct lending index, direct lending has had annualized losses in line with the JPM Leveraged Loan Index and significantly less than the high yield over the past 1, 5, 10 and 20 years. In addition, any systemic risk must be in the context of business model of the business model and we believe private credit has a superior business model.

Speaker 2

Unlike banks, where the business model is lending long and funding short, private credit is match funded. As students of all types of models and financial services, the tail risk typically comes from liquidity issues and in its core a poor asset liability matching model. This was apparent in the regional banking crisis. Furthermore, unlike banks who have some protection through the FDIC program, a taxpayer put doesn't exist for private credit vehicles. And finally, we can't ignore the differences in capitalization.

Speaker 2

Risk bearing capital inside banks is somewhere between 9% to 12% versus private credit between 25% 50%. That being said, we are sure there will be dispersion and results in private credit. Dispersion, however, shouldn't be conflated with systemic risk. With that, thank you for the time today. Operator, please open up the line for questions.

Operator

Certainly. And our first question will come from Brian McKenna of Citizens JMP. Your line is open.

Speaker 5

Okay, thanks. Good morning, everyone. My first question is on the trajectory of adjusted NII. It stepped down $2,500,000 sequentially in the quarter. So what was the biggest driver of that?

Speaker 5

I know you added 1 company to non accrual status during the period. So does that contribute to the step down at all? And then how much did tighter spreads impacted on a per share basis? And I'm just trying to get a sense of a good jumping off point for NII in Q2 and beyond.

Speaker 6

Yes. Hi, great. Thanks for the question. It's a good question. So the non full was as of the end of the quarter, so had very little to no impact on NII.

Speaker 6

I think the drivers of NII that Ian let it out was a small impact on I would call it 3 things. 1 is base rates were down 5 basis points, a small amount quarter over quarter. So the curve although the curve is up and it's higher for longer, the curve is downward sloping. So that's a piece of it. Spreads had a very small impact as well.

Speaker 6

So yield and amortized investments went from, I think it was down 20 basis quarter over quarter, which 5 of that was 6 base rates in fact

Speaker 2

took place rates. So 15 basis points. And then

Speaker 6

the rest was just kind of episodic fees, which I think Ian laid out. So when we think about our business, I think we still feel very comfortable with our guidance on adjusted NII for the year, which was in That was the 13.4 NII. Yes. Got it. Okay.

Speaker 6

Yes, that's helpful. Just in II was 227. I think we still feel very comfortable with that.

Speaker 5

Yes. Okay. Got it. Thanks. And then maybe just a follow-up.

Speaker 5

So spreads have clearly tightened here over the past several months. And if I look at new floating rate commitments in the quarter, spreads declined about 100 bps on average from the Q4. So I guess my question is bigger picture around originations and just with spreads where they are and more liquidity broadly in both public and private credit markets, how are you making sure you're getting the right economics for the risk you're taking today, specifically as we move further into the current cycle?

Speaker 6

Yes. Again, I think these are really good questions. I think the easiest way to see the economic value of what we're providing to shareholders is actually related to the equity rates this quarter. So yields this quarter, I think we went through the math clearly, but yields this quarter were somewhere between yield average life of 11.5% 14% on an average life basis with the swap curve. And that will bring ROEs similar into that range compared to our cost of equity of 9%.

Speaker 6

So even in this spread tightening environment, you've seen, I think, value to our shareholders vis a vis our cost of equity. Look, we were clear and I think the good news for our SBLOC shareholders is we were one of the few public BDCs that had capital available to invest in the last vintage. And most definitely because of that, we're going to have a portfolio that kind of over earned. But even in this most recent quarter vintage, we are we have the ability to significantly out on your cost of capital and provide value to our shareholders. Yes.

Speaker 5

Okay. I'll leave it there. Thanks, Josh.

Speaker 6

Just let me round out the points, I think it's helpful. Just because spreads have declined doesn't mean that we're not providing significant value to our shareholders. You can clearly see that even in this quarter's vintage given our cost of equity. Yes. Got it.

Speaker 6

Thank you.

Operator

And one moment for our next question. Our next question will be coming from Maxwell Fichter of Truist. Your line is open, Maxwell.

Speaker 7

Hi, good morning. I'm calling in for Mark Hughes. Kind of along the lines of Brian's question, with the higher competition, more capital being provided, are you seeing any companies becoming more comfortable with increasing their M and A activity? And if so, how do you see this shaking out throughout the year?

Speaker 6

Yes. Look, I would say as the forward curve I would expect activity levels generally to be up. So I don't think we saw a little bit of that in Q1. When you look at Alteryx, for example, which was a take private, you saw Truck Lite Co, which was a M and A, which was a portfolio company, which was a strategic investor owned by a sponsor buying another strategic asset. So you saw a little bit of that this quarter.

Speaker 6

I think as volatility and the rates markets subside and as rates come down a little bit, I think you'll see more activity. I think that more activity will have 2 impacts on our business. 1 is, it will hopefully increase portfolio churn on the margin, which will drive additional economics that we haven't seen. It's kind of dried up. That's been historically a driver of our return on equity.

Speaker 6

But I think you'll if you see activity levels, you'll see that portfolio churn, which will drive through economics of our business. And then there will obviously be more activity on the front end of things to do. So Bo, anything to add there? No. I expect to see

Speaker 3

M and A activity continue to strengthen after a pretty anemic couple of years, both because of better financing costs, but also because equity valuations are coming there's more parity between buyers and sellers as public equity markets have strengthened. And also a lot of businesses have grown into some of their valuations. So you're going to see better assets come to market over the next few quarters, and we're starting to see that in our pipeline today.

Speaker 7

Thanks. That's very helpful. And Josh, you mentioned last quarter and correct me if I misunderstood, but you were hopeful for more opportunities in 2024 to strategically invest in good companies with bad balance sheets. Any developments on this front thus far?

Speaker 6

Yes. We didn't even ask you to ask that question. I think we asked people to ask that question. But Equinox is a pretty good example of that. Equinox is a portfolio company of 2 strong sponsors related to like partners.

Speaker 6

It was a company that was obviously COVID impacted, but it's one of the premier companies in the fitness space. It really only has one competitor and is a great company with a great brand and great unit economics, but obviously COVID happened and enacted that business and their balance sheet got complicated. And so we led up $1,200,000,000 senior secured first lien facility in connection with the new second lien facility by the sponsor and others to refinance that probably syndicated loan capital structure. We held roughly half of the investment And so we were relieved, but we partnered with Ares and HPS. And so that was a business, an opportunity that we were super excited about and then it was complicated with part of private equity due diligence and was kind of right in the middle of good company, bad balance sheet that needed that was complicated.

Speaker 6

But we really like both the sponsors in that business, we're very good stewards of that business and supportive and management team and the management team including the CEO. So we're excited. We think we're going to be given the rate environment and the higher for longer narrative, there's going to be many of those same situations that I think go right in our wheelhouse where we're going to have to provide capital, where we have an opportunity to provide capital that generates strongest adjusted returns for our shareholders.

Speaker 7

Great. Thank you.

Operator

And one moment for our next question. Our next question will be coming from Finian O'Shea of WFS. Your line is open, Finian.

Speaker 4

Hey, everyone. Good morning.

Speaker 8

Josh, on your sort of the segueing there, but on your opening comments on the firming of the rate curve and the expected dispersion we'll see, Is that happening in real time, say in response to the rate curve? Are you seeing reorgs or LMEs and so forth? And on the in private credit and on the flip side, should that translate to a more abundant deployment opportunity?

Speaker 6

Good to hear your work. I think hopefully you're on the East Coast or on the West Coast, we're kind of waiting out here. But I think that's a good question. So I think our theme has been that Hire Longer is a 2 kind of there's 2 petech point. The first petech point is companies are going some companies are going to have problems in that environment, both due to demand, which demand for the products and services.

Speaker 6

And the second is their balance sheet and that their cost of increase is most definitely in their interest cost. And so there's most definitely going to be issues. Hopefully, I think in general those and that will cause dispersion between I and net income and total economic return. And we see that a little bit on that margin. Astra, we put it out there like non pools are growing so well for us at fair value 1.1%.

Speaker 6

Anthology, which is we hold a small technical position, we put on non accrual, We took a mark down. That is still paying cash by the way. That will still pay cash, I think, to maturity. That will be the cash on cash returns are like in the 30s on compared to fair value. That should be a tailwind in that asset value as we're taking that into amortized cost.

Speaker 6

But there will be small tails that pop up. We think those tails will be manageable for the industry. And given how much capital the industry holds, it shouldn't create any existential risk for the industry. On the flip side, that should provide a great opportunity for those who can deploy capital into those companies that help facilitate those LMEs or those restructuring like Equinox. So I think it's a double edged sword.

Speaker 6

I think the glory locks is you were good on credit, which we think we are and that we you have capital deploy either because the market trust you to raise where you can raise more capital, which they will certainly have or you have excess balance sheet plus you have the requisite skill set to actually execute on those transactions, which we most definitely have, which will create good deployment opportunities. And so that's the Goldilocks. We think we're in that. We think we have all those pieces of the Goldilocks, But we think it's going to be really interesting environment for the next couple of years given the higher for longer is going to and capital is misallocated in some ways given low rates that this will be a good opportunity to participate in the opportunity set. But I think you need capital, which a lot of the industry doesn't have given more trades, you need the requisite skill set and then you need a clean portfolio.

Speaker 8

Very good. Thanks. And a follow-up, looks like the last out leverage has been somewhat declining last handful of quarters at least. Seeing if this is market related or portfolio related, are you managing it down? And if we should expect that to continue and what it means for returns?

Speaker 6

Yes. Look, what I would say is we have we think on the margin, there are the opportunities that today is in larger companies, larger capital structures. And in those companies, given how big those credit facilities are, it's hard to club together somebody taking a 1st out revolver. And so by number, my guess is that's going down given what we think the opportunity set is, but that will kind of go up and down. That's a combination of, I think, 2 things.

Speaker 6

1 is the large capital structure. The second thing is banks are still capital constrained, and we see that with a lot of our bank partners on the margin. So it doesn't have a huge drop impact it doesn't have a huge impact on economic returns. But it's really both two things, which is where we see the opportunities that is and

Speaker 3

how big the position.

Speaker 8

Thank you.

Operator

One moment for our next question. And our next question will be coming from Robert Dodd of Raymond James. Your line is open.

Speaker 9

Hi, everybody. I hope you can hear me okay. On the comment just you made, the tail is going to get fatter. I mean, the longer rates stay up, obviously, it's going to get longer and fatter. I mean, look at your portfolio tick went up a little bit sequentially.

Speaker 9

It looks like that was mainly new investments though. Your unfunded commitments ticked up. Again, it looks like it was mainly new investments, but it's hard to tell. Can you give us any color on are you seeing incremental revolver draws more broadly? I mean, obviously, there's a couple of assets, right?

Speaker 9

Astra, for example, you just put on a call that having some idiosyncratic issues. But are there any emerging signs in the portfolio that this hire for longer is starting to create pressure in terms of liquidity and liquidity leads?

Speaker 6

No. And just coverage is actually flattening out the increase. Earnings, I think, on a same store basis grew about 10% quarter over quarter. Revenues grew by about 5%. I think answer is no.

Speaker 6

I think some of the unfunded commitment increase quarter over quarter was all tariff I think where they're going through a process to with a negotiating with the bond orders to call those bonds in. But no, broadly speaking, we don't haven't seen that pressure. And then obviously from an ALM perspective, we reserve for unfunding commitments announced close to 3 times post our bond maturity of liquidity for unfunded commitments. So kind of deem stress like broad based stress, interest coverage is kind of bottomed out as on the rise given earnings growth plus a combination of the 4th curve, although higher for longer, it's still declining. So no.

Speaker 6

Got it. Thank you. On

Speaker 9

the other fee income, obviously, it was low again this quarter, not a huge surprise. But if we go higher for longer, if there's less activity there, are we in do you think there's a risk of relatively prolonged period of lower other fee income from the portfolio given obviously the less activity, the older the assets get, the older they get, the less fee income they generate if they do anything anyway. So is there a little bit of a low cycle here that could progress all the way through 2024, maybe even 2025 until the portfolio gets recycled? Or is it just transitory?

Speaker 6

Yes. I think that's a great question. Hard to model. What I would say is, I think there's us and the industry. First, historically, we've had more of this type of income.

Speaker 6

2nd, I think so I think we can agree on that. So but the question is, is it how does that impact us? I think when you look at our portfolio, unlike the rest of the industry, we were actually able to deploy post rate hiking cycle. And so we have more vintage in 2022 and 2023. And so that was in the absolute higher spread environment.

Speaker 6

So I think you're going to either one of 2 things will happen is one is we'll hold those assets for longer, which should over earn all those assets for churn if we can all agree to spread the comment in a little bit, which will create income. So we have 43% of the percent of the portfolio was invested in the second half of twenty twenty two. So I think we were given how we've managed the business and how focused we've been on being good allocators of capital, the market has rewarded us with the ability to give us more capital, which allowed us to during the efficient cycle, it allowed us to invest in 2022, 2023 vintage in a higher spread environment, which my guess will at some point churn. Got it. I think you have to like split out between the industry and us and we just have more 2022, 2023 vintage and we all agree spreads to come in.

Speaker 6

Yes, understood. Thank you.

Operator

And one moment for our next question. Our next question will be coming from Eric Juve of Holt Group. Your line is open.

Speaker 10

Good morning, everyone. First question is maybe a 2 part question. Beau noted that competition, you guys have talked about it in subsequent answers, so the competition has increased since last year. And I'm curious if that is manifesting primarily just in compressed spreads and on the pricing side or if you're seeing anything on the structure side as well. So that's the first question.

Speaker 10

And I guess the second would be, one of your slides you note that the peer portfolio, the weighted average number of covenants per credit agreement is 1.8. I'm curious if that has changed over time or if that's been pretty consistent as well.

Speaker 6

It most definitely will be on the margin into the document. The documents are sold better than relative to the KOL documents, but it doesn't just stop the door of spreads. So but we still feel comfortable with the overall package. And then I would say there is a hold on the tail of 2 cities. We most definitely have seen the opportunities that upmarket.

Speaker 6

And on upmarket, there is those documents there

Speaker 3

might be a few

Speaker 6

or less financial covenants. And so but that is a we're making a choice between the trade off between credit quality, size of company and protections. And we think the relative value is still very good there. Just to size it up, not everybody there's a handful of people who can write $500,000,000 checks. There's a lot of people that can write $40,000,000 to $50,000,000 checks.

Speaker 6

And so in this moment in time, it always won't be that case. We've moved up market. You can see that in our underlying EBITDA, average EBITDA portfolio company that's the fine metric. I think it's gone from 35 a couple of years ago to 90,000,000,000 was the average now. Now?

Speaker 6

It's over 90. Over 90,000,000. So anything to add there, Bo? No, the only thing

Speaker 3

I would add is we continue to only invest in situations where we have control or influence on the documentation. And with competition, you're going to see you lose your documentation, but we still have we still control that and tend to only play in situations where we believe the document still has the protections that we need as investors. So we have seen loosening of terms certainly from 18 to 24 months ago when docs got really tight, but they're still adequate to protect our capital.

Speaker 10

Thanks. I appreciate the detailed commentary there. And I guess just the only remaining question for me and you just noted the ability to write large checks. And if I look at Slide 6 and average investment size in your portfolio, if I look at it, excluding the structured credit investments, it's actually down a little bit year over year. However, if they include the structured credit, it's up year over year.

Speaker 10

So just curious about the kind of the divergence there and what's transpired on the structured credit side over the past year or so?

Speaker 6

Yes. The divergence has we've increased diversity in our portfolio for sure over time and our capital base is relatively fixed in SOX. And so it's participating in larger deals across the platform, but our capital base is relatively fixed in SOX and we've been focused on increasing diversity. So I hope I I think I got that question. Yes.

Speaker 6

Thank you. That's all

Speaker 10

for me. Appreciate the answers.

Speaker 6

Thank you so much.

Operator

One moment for our next question. Our next question will be coming from Melissa Wedel of JPMorgan. Your line is open.

Speaker 11

Good morning. Most of my questions have already been answered, but I wanted to follow-up on your comment, Josh, about the opportunity set right now. You're seeing it really with the larger companies and bigger capital structures. Based on Ian's comments, it seems in very detailed analysis of what the return threshold is for new investments and where you are able to source what you're able to source in the Q1. Certainly, it looks like you're able to clear that threshold by a couple of 100 basis points at least in the Q1.

Speaker 11

But as competition increases, I guess the question is, do you see the opportunity set evolving more in the more complex deals? And you talked about a couple of those that you guys done in the Q1. Is that where the economics are? Is that where we should think about you being involved primarily in the next few quarters?

Speaker 9

Let me tell you the power. I think this is

Speaker 6

at the heart of our platform. I think this is Six Tree. So I mean, I may go down a rabbit hole and then you can pull me up for a second. So 63, I think people know $77,000,000,000 or $75 plus more of assets through management, 600 plus employees. We have people sitting across industries and verticals and focused on companies in all parts of their life cycle.

Speaker 6

And that includes by sector, by size and then by where they are in the lifecycle from growth vectors from size of the company, all those vectors from size of company to where they are in their life cycle to what sectors we think are interesting. And at some point, sectors are thrown out for no reason

Speaker 10

and we think they're interesting and

Speaker 6

we can deploy capital there. Think of that as energy, which our returns have been very good. At one part, it was retail and consumer. And in software, we have a differentiated view. And so we're really a relative value buyer across a big top of the funnel.

Speaker 6

That is our business model. And so the answer is, I don't know the difficult part of capitalism, if capitalism is working is when there's excess returns, the capital flow. Is you kind of have to keep chucking and jiving through the opportunity set. That is the power of the business. And so it might be retail for 6 months or 9 months, it might be software business services, it might be industrial, it might be energy, it might be small cap, it might be large cap.

Speaker 6

The power of the platform that what we're delivering to investors is our ability to cross those opportunities that where we have a closer to platform where we can collaborate, where we can deliver that to people. And so that is what we have built for people. That's what we'll continue to lean on. And so I know across environments, across opportunities that we're just not a monoline business and that is where the durability of the returns come from.

Speaker 11

Okay. I appreciate that overview and reviewing of the opportunistic nature of what you guys are able to do. Maybe I should have rephrased my question a little bit just in terms of really sort of the pipeline on complicated investments and that idea of the good company, bad balance sheet in a higher for longer environment, are you expecting more of that?

Speaker 6

I would hope so. I mean, look, my macro view is difficult for the Fed to pivot. We've been saying this for a long time, the Fed hasn't pivoted. And that's going to cause stress in capital structures. And so my hope is that will be that like Equinox, that will be interesting.

Speaker 6

We did a test in Q1, which is public for $0.99 which is a retail business. That liquidation is going very well. And so we like that opportunity. That is my hope. That is kind of right into the strike zone of the platform.

Speaker 5

Thanks, Josh.

Speaker 6

You got me all excited about what the platform delivers for value add. So sorry, I had to go down the rabbit hole.

Operator

Okay. All good. And one moment for our next question. And our next question will be coming from Bryce Roe of B. Riley.

Operator

Your line is open.

Speaker 12

Thanks. Good morning. Wanted to maybe just continue on this theme of churn within the portfolio and just churn generally within the industry. You all have clearly focused on putting money to work in 2022 and 2023 vintages and addressing any kind of maturities that we that you have in 2024 and 2025 and those are now kind of more limited. So if you could kind of talk about or size up the opportunity from an origination perspective versus what we might see from a repayment perspective within the portfolio and what that might mean for kind of net portfolio growth as we look forward?

Speaker 12

Thanks.

Speaker 6

I would on the margin, I would think net portfolio growth. And I guess it's hard because we're very kind of opportunities debt driven. But I would say on the margin payments will increase because of our exit of our vintage of 2022 and 2023. And I would say on the margin, I would expect our balance sheet to remain stable and not grow as significantly as it did in the last 18 months. That would be my guess.

Speaker 6

I mean, look, we want to lean in, in environments where there's really, really high risk adjusted returns. We can agree that with 20 2, 20 3 and grow the balance sheet. And not everybody can do that given their access to capital, but we did that. And then which will mean that portfolio term will increase on a growth basis. On that basis, the opportunity set is going to be marginally less.

Speaker 6

And so I think that means that our balance sheet will be relatively stable, maybe slightly growing, but it's not going to grow because they said and did only last few months. Months. Okay. Okay.

Speaker 12

And then maybe one more for me on the capital structure. I mean, you've been opportunistic in terms of raising both debt and equity. As you and you've talked about kind of having pre funded the 24 notes. Do you think about layering in another I guess another round of notes given how open debt capital markets are today just given yourself that much more liquidity or available liquidity as we think about capital structure?

Speaker 6

Yes. I think we talked about this a little bit. I think it's a good question. I actually think on the margin, we hold too much liquidity today. So if you kind of think about if you look at the post refi of the 24 notes, we have about $750,000,000 of liquidity.

Speaker 6

And we can't give it our the constraint is debt to equity, which ranges 0.9 to 1.25. We can't really use that liquidity if you don't think we're growing the net asset value of the business through new equity ranges. And so if we were to our choices would be to give back unfunded commitments to banks, which I don't think we want to do because that's a low cost capital. If we were to raise more bonds. I don't see we have and that liquidity I think is very valuable and is really good insurance, but it's limited given the constraint of our 1.25 debt to equity and how much our capital looks today.

Speaker 6

So I don't see us and it has an economic cost to shareholders. So I don't see us doing a bond deal unless we think we can grow growth assets, which will require us to grow through an equity raise because we just have a whole bunch of capital equity that's an economic cost to shareholders. Got it. Okay. Appreciate the color.

Operator

And I'm showing no further questions. I would now like to turn the conference back to Josh for closing remarks.

Speaker 6

Thank you. Look, I appreciate the time as people are heading into summer and the weather is turning, I hope people get to spend that with their families and enjoy their summer. We'll obviously be back in contact at 94 in August, please vote in our shareholder meeting. It's a democratic process as well as democratic processes are really, really important. But thank you for your time and we're always around to answer questions.

Speaker 6

And I thought today's questions were really, really good. So thanks for the analyst community for putting in the work.

Operator

And this concludes today's conference call. Thank you for participating. You may now disconnect.

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Earnings Conference Call
Sixth Street Specialty Lending Q1 2024
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