Sixth Street Specialty Lending Inc (TSLX) 2018 Q2 法說會逐字稿

Good morning, and welcome to TPG Specialty Lending Inc.'s June 30, 2018, Quarterly Earnings Conference Call.

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 TPG Specialty Lending, Inc.'s filings with the Securities and Exchange Commission. The company assumes no obligation to update any such forward-looking statement.

Yesterday, after the market closed, the company issued its earnings press release for the second quarter ended June 30, 2018, and posted a presentation to the Investor Resources section of its website, www.tpgspecialtylending.com. The presentation should be reviewed in conjunction with the company's Form 10-Q filed yesterday with the SEC. TPG Specialty Lending, Inc.'s earnings release is also available on the company's website under the Investor Resources section.

Unless noted otherwise, all performance figures mentioned in today's prepared remarks are as of and for the second quarter ended June 30, 2018. As a reminder, this call is being recorded for replay purposes.

I will now turn the call over to Josh Easterly, Chief Executive Officer of TPG Specialty Lending, Inc.

Thank you. Good morning, everyone, and thank you for joining us. I will start with an overview of our quarterly results and hand it off to our President, Bo Stanley, to discuss our origination and portfolio metrics for the second quarter. Our CFO, Ian Simmonds, will review our financial results in more detail. And I will conclude with the thoughts on the SBCAA and our financial policy along with final remarks before opening the call to Q&A.

After market close yesterday, we reported strong second quarter financial results with net investment income per share of $0.56 and net income per share of $0.52, both of which exceeded our second quarter base dividend per share of $0.39.

Our Q2 results imply an annualized return on equity on net investment income and net income of 13.8% and 12.7%, respectively. The difference between the net investment income and net income this quarter was primarily driven by the negative impact of mark-to-market losses of interest rate swaps related to our fixed-rate securities.

Net asset value per share at quarter-end was $16.36, an increase of $0.15 compared to the prior quarter, after giving effect to the impact of the Q1 supplemental dividend, which was paid during Q2. Net asset value movement during Q2 was primarily driven by the overearning of our base dividends, the positive impact of net unrealized gains associated with certain portfolio companies, partially offset by unrealized losses through the widening of credit spreads quarter-over-quarter and the aforementioned impact of our swap instruments.

Yesterday, our board announced a third quarter dividend of $0.39 per share to shareholders of record as of September 14, payable on October 15. Our board also declared a Q2 supplemental dividend of $0.08 per share to shareholders of record as of August 31, payable on September 28. Since introducing our variable supplemental dividend framework in Q1 of 2017, we declared a total of $0.36 per share in incremental dividends as net investment income per share exceeded base dividend per share in each of the past 6 quarters.

Along the way, we've increased net asset value by 2.1% from $15.95 to $16.28 per share, after giving effect to the impact of the $0.08 Q2 supplemental dividend to be paid in Q3. We believe our dividend policy, which seeks to maximize shareholder distributions while protecting and steadily growing net asset value over the long term, offers a differentiated shareholder experience that distinguishes us in the space.

During Q2, there were a few active names in our portfolio that I'd like to provide updates on, namely, iHeart and Rex. As shared on our last call, iHeart filed for Chapter 11 in late April. And in June, we were refinanced out of our asset-based loan upon the funding of the company's new debtor-in-possession financing. Along with the repayment of our loan principal, we received cash payments on post-petition interest and prepayment fees totaling $3.6 million, which included $592,000 of certain interest income that we reserved against. In July, the unsecured credit committee of iHeart filed an objection on certain portions of income received by the ABL lenders, which we believe to be meritless. A hearing on that objection is currently scheduled for the fall, and we're optimistic that we'll be able to recognize our reserve portion of interest income of approximately $0.01 per share upon resolution of the issues pertaining to the committee's objection.

On May 18, Rex Energy filed a voluntary petitions of relief under Chapter 11 of the Bankruptcy Code with a restructuring support agreement between the company's first lien and majority of the second-lien lenders. The agreement stipulates, among other things, that proceeds from the sales of substantially all of the company's assets would benefit the entirety of the prepetition first-lien and DIP obligations, including make whole premiums. Since we did not have any visibility on potential proceeds of the asset sale process during Q2, our income reflects a reserve of $3.1 million related to a portion of the Rex prepayment fee. Final bids for the sale process were due last week with an auction scheduled for August 16. We're optimistic that we'll be able to take our fee reserve off during Q3, which will contribute approximately $0.05 per share to next quarter's income. Given the milestones of the bankruptcy case, we expect to be repaid by the year-end 2018.

With that, I'd like to turn the call over to Bo, who will walk you through our quarterly originations and portfolio metrics in more details.

Thanks, Josh. Q2 marked our second-highest origination quarter since inception at $944 million, resulting in fundings of $222 million distributed across 4 new investments and 6 existing portfolio companies. Of the $944 million of gross originations, $679 million were allocated to affiliated funds or syndicated to third parties, and $44 million consisted of unfunded commitments. On the repayment front, we had 4 full realizations and sell-downs totaling $183 million aggregate principal amount, $117 million of which was attributed to iHeart.

As for our investment environment, we believe competition is starting to stabilize, and quarter-over-quarter first-lien LCD spreads widened for the first time since Q4 of 2015. Our investment strategy in today's late-cycle environment has been focused on opportunities where we have a competitive advantage and the ability to structure strong lender protection features.

Nearly a quarter of our gross originations on a dollar basis in Q2 were in existing portfolio companies where our preexisting knowledge of borrowers and sectors supported our ability to drive pricing and terms. Further, 95% of gross originations on a dollar basis were in agented transactions, which we view to be valuable for shareholders given admin agents' important role in managing credits and ability to conduct private equity style due diligence.

We continue to be thematic in our approach to originations, focused on opportunities that correspond to our platform's sector expertise and relationships, as well as opportunities arising from market dislocations where our competitive advantage of size and scale, given our SEC exemptive relief allows us to underwrite attractive risk rewards.

A good example of this is the $575 million senior secured credit facility that we completed for Ferrellgas during the quarter, which Josh referenced on our last call. Ferrellgas is a publicly traded distributor of propane with an enterprise value of $2.3 billion. The company has a defensive core business with a high return on invested capital and a strong management team, but face refinancing difficulties given the challenging regulatory environment for banks. Due to our ability to provide a fully underwritten financing solution through co-investments from affiliated funds, we were able to structure a first-lien, last-out position at a low attach point of 0.2x and a low net leverage of 1.7x with highly attractive risk-adjusted returns. Further, as we sized down our originations amount to the target holder of our portfolio, we were able to drive additional economics for our shareholders through syndication income. At quarter-end, our investment in Ferrellgas represented our largest position at 4.2% of the portfolio at fair value.

Now let me take a moment to provide an update on our portfolio metrics and yields. Despite recent competitive dynamics, we remain committed to high documentation standards and meaningful terms that provide robust downside protection. At quarter-end, we maintained effective voting control on 84% of our debt investments and an average of 2.3 financial covenants per debt investment, consistent with historical levels. As for managing prepayment risk, the fair value of our portfolio as a percent of call protection is 95.6%, which means that we have protection in the form of additional economics should our portfolio get repaid in the near term.

At June 30, the weighted average total yield on our debt and income-producing securities at amortized cost was 11.4% compared to 11.2% at March 31. This increase was due to the upward movement in the effective LIBOR on our portfolio -- debt portfolio--as well as the impact of higher yields on new versus exited debt investments. The weighted average yield at amortized costs on new and exited debt investments during the second quarter were 11.2% and 10.5%, respectively. Note that the yield on new investments includes our first-lien, last-out loan for Ferrellgas, which has pricing subject to the amount outstanding under the company's first-out revolver. In Q2, working capital draws on the first-out revolver were low given seasonality in the business, which resulted in lower additional spread on our loan. If the maximum additional spread were to be applied, which we'd expect to be the case during certain periods of the year, the yield at amortized cost of our Ferrellgas investment would have been 11.0% versus 10.1%, and the yield at amortized cost on new investments for this quarter would have been 11.6% versus 11.2%.

Overall, the upward trend in portfolio yields is reflective of the floating rate nature of our assets in a rising rate environment, supported by our differentiated source and structuring capabilities. At quarter-end, 99% of our portfolio by fair value was sourced were through non-intermediated channels.

As it relates to portfolio of construction, we remain defensive given the late cycle environment. We continue to be first-lien oriented with 94% of our investments by fair value being first lien at quarter-end compared to 82% in Q1 2014. Over the same period, we've decreased our cyclical exposure, including energy, from 28% to 10% at quarter-end. Adjusted for the expected payoff of Rex, this figure would have been 8.3% at quarter-end. Our cyclical exposure, excluding energy, has decreased from 19% in Q1 2014 to an all-time low of 3.6% at quarter-end.

Our portfolio today is well diversified across 48 portfolio companies and 17 industries. Over the last 12 months, we've enhanced the diversification profile of our portfolio, decreasing our top 10 investment concentration from 40% to 35% of the portfolio at fair value, and our largest industry exposure, which is to business services, from 23% to 18% of that portfolio at fair value.

From a portfolio quality perspective, there were no investments on nonaccrual at quarter-end. Overall portfolio performance continues to be steady with weighted average rating of 1.24 based on our assessment scale of 1 to 5, with 1 being the highest. Across the portfolio, since inception to June 30, we've generated an average gross unlevered IRR weighted by capital invested of approximately 19% on fully realized investments, totaling over $2.9 billion of cash invested.

with that, I'd like to turn it over to Ian.

Thank you, Bo. We ended the second quarter with total investments of $1.96 billion, total debt outstanding of $875 million, and net assets of $1.06 billion or $16.36 per share, which is prior to the impact of the $0.08 per share supplemental dividend that will be paid in Q3. As Josh mentioned, our net investment income was $0.56 per share, and our net -- and our net income was $0.52 per share.

During Q2, we chose to operate slightly above the top end of our target leverage range of 0.75x to 0.85x given our visibility into the timing of the repayment of our position in iHeart, which occurred in June. As a result, our average debt-to-equity ratio increased quarter-over-quarter from 0.84x to 0.89x. While we had the ability to issue equity during this period, we chose not to in order to optimize ROEs for our shareholders. Finally, our leverage at quarter-end remained consistent with the prior quarter at 0.82x. For clarification, when we quote leverage metrics, we use the principal amount of outstanding debt in our calculation, rather than the balance sheet amount, which is shown net of deferred financing cost.

Since our last earnings call, we continue to be active in the capital markets this quarter on the debt side, opportunistically reopening our 2022 convertible notes and increasing our total principal amount outstanding from the $115 million to $172.5 million. The transaction priced at a slight premium to par, resulting in a swap-adjusted pricing on the upsized portion of LIBOR plus approximately 160 basis points, which is well inside the swap-adjusted spread on both the original notes and the spread on our secured revolver. We executed this transaction because it allowed us to improve our unsecured funding mix with no material impact on our weighted average cost of debt and, therefore, minimal drag on our pro forma ROEs.

Moving back to our presentation materials. Slide 8 contains an NAV bridge for the quarter. Working through the various components, we added $0.56 per share from net investment income against a base dividend of $0.39 per share. $0.02 per share of accretion was related to our capital markets activity during the quarter, both from the exercise of the overallotment option relating to the equity offering we completed in Q1, as well as the equity component of the additional convertible notes we issued in Q2. There was an $0.08 per share reduction to NAV as we reversed net unrealized gains from full investment realizations on the balance sheet and took their respective accelerated OID and/or prepayment fees through investment income. This quarter, changes in credit spreads had a negative $0.01 per-share impact on the valuation of our portfolio, and we had $0.03 per share of negative impact to NAV from unrealized mark-to-market losses related to interest rate swaps. Other changes, including net unrealized gains specific to certain portfolio companies, contributed $0.08 per share of positive impact to NAV. Finally, applying the declared supplemental dividend of $0.08 per share to our reported NAV per share at June 30 of $16.36 provides a pro forma NAV per share of $16.28.

I'd like to take a moment to talk about our risk management approach, specifically as it relates to interest rate risk. At our core, we are spread lenders, focused on maximizing the net interest spread between our assets and liabilities. We believe we have limited competitive advantage in making directional calls on interest rates, and therefore, we mitigate this risk through fixed to floating swaps on all of our fixed-rate liabilities. As discussed on our last call, upward movements in the shape of the forward LIBOR curve have the effect of creating mark-to-market losses on our outstanding swaps. These losses will never be realized unless we choose to change our financial policy and unwind swaps prior to their respecting maturity dates, which we don't expect to do. For reference, our Q2 NAV includes cumulative swap-related unrealized losses of $0.11 per share that will unwind over time as we approach the maturity date on each swap instrument.

Some of the notable aspects about our floating rate liability structure is the downside protection it provides during recessionary environments when the central bank lowers rates to stimulate GDP growth. When this occurs, the cost of our liabilities will decrease in line with the drop in LIBOR, while our asset yields will only decrease to the extent LIBOR reaches the average LIBOR floor across our debt investments. Said another way, our floating rate liability structure, in combination with the LIBOR floors that we structure into our assets, provides earnings support in the form of net interest margin expansion during challenging economic environments.

Moving to the income statement on Slide 10. Total investment income for the first quarter was $66.4 million, up $8.6 million from the previous quarter. Breaking down the components of income. Interest and dividend income was $55.5 million, up $8.7 million from the previous quarter, given the predominantly quarter-end timing of new Q1 fundings and a higher effective LIBOR on our investment portfolio.

Other fees, which consist of prepayment fees and accelerated amortization of upfront fees from unscheduled paydowns was $7.6 million for the quarter compared to $5.1 million in the prior quarter as a result of higher accelerated amortization of upfront fees, the majority of which was related to the repayment of iHeart. Other income was $3.3 million for the quarter, a decrease of $2.6 million compared to the prior quarter. Note that our fee income this quarter reflects reserves totaling $0.06 per share or $0.05 per share on a post incentive fee basis related to 2 investments that Josh referenced in his opening remarks. Again, we expect these reserves will be recognized into income in our Q3 results as we reach resolution on these 2 investments.

Net expenses for the quarter were $29.2 million, up from $25.7 million in the prior quarter primarily as a result of higher interest expense and incentive fees. Interest expense was higher in Q2 due to an increase in the effective LIBOR rate on our outstanding debt and an increase in the amount of average debt outstanding. While LIBOR was relatively flat during Q2, the lag in timing of LIBOR resets on our debt tranches meant that we experienced the impact of LIBOR's rise during Q1 more fully this quarter. Our weighted average interest rate on average debt outstanding increased by approximately 40 basis points quarter-over-quarter. On a year-to-date basis, our funding cost beta is approximately 1 as our weighted average interest rate on average debt outstanding increased by approximately 65 basis points, which corresponds to the year-to-date increase in LIBOR.

At quarter-end, we had significant liquidity with $501 million of undrawn revolver capacity subject to regulatory constraints and remain much funded from both an interest rate and duration perspective.

Before passing it back to Josh, I wanted to provide an update on our ROE metrics. Year-to-date, we've generated strong annualized ROEs based on both net investment income and net income of 13.3%. We believe this reflects our strong originations platform, our ability to embed economics into our portfolio as well as our continued focus on optimizing our capital structure through the lowest funding costs we can obtain. Given our strong year-to-date ROEs and our outlook for the remainder of 2018, we are updating the upper end of our full year 2018 NII guidance from $1.85 per share to $2 per share.

With that, I'd like to turn it back to Josh for concluding remarks.

Great. Thank you, Ian. We are pleased that our financial results this quarter continued to result in incremental distributions to our shareholders, which has resulted in a book dividend yield of 11.1% over the LTM period. Before closing, I'd like to provide an update on our plan in with regards to the lower asset coverage requirements permitted under the Small Business Credit Availability Act, which was passed into law earlier this year. As discussed in our last call, our general viewpoint is that the regulatory relief is in itself a positive for shareholders and the creditors in the sector as it increases the buffer for breaching asset coverage requirements, which will constrain the sector from further borrowings, paying shareholder distributions and interest on debt. Again, we believe that potential application for leverage changes may provide a great opportunity for a select few in the sector but could create meaningful incremental risk for most of the sector's shareholders given the median returns on equity that have been generated have been below the sector's cost of equity.

In assessing our financial policy in light of the regulatory change, we incorporated feedback from our stakeholders, including our shareholders, bondholders, lending partners and rating agencies and overlaid it with our philosophies on capital allocation, risk management and protection of capital. Ultimately, we came to the conclusion that obtaining regulatory relief with a modest change in our financial policy and a continuation of our rigorous risk management framework would be in the best long-term interest of our stakeholders.

Yesterday, our board approved reduction of our minimum asset coverage ratio from 200% to 150% and unanimously recommended that TSLX shareholders approve this proposal at a special meeting of the shareholders, which would allow the lower asset coverage requirement to apply earlier than August 1, 2019. We anticipate holding a special meeting at the earliest practical date.

Our financial policy, upon the effectiveness of the lower asset coverage requirement, would be to increase our target debt-to-equity range to 0.90x to 1.25x, while making no changes to our dividend framework and our funding approach. At this new target leverage range, we believe that we will be able to maintain our investment-grade rating, which continue be the highest priority for the business.

Our investment strategy will also remain unchanged. We will continue to focus on directly originated first-lien senior-secured investments with attractive risk-adjusted returns. Our current thinking with incremental leverage capacity is to grow assets organically over time when the market opportunity set permits and further enhance the diversification profile of our portfolio. In periods where our average debt-to-equity ratio exceeds 1.0x, we would look to implement a base management fee waiver of 50 basis points on the proportion of asset financials greater than 1.0x leverage.

Our decision to pursue a lower asset coverage requirement is based on the careful assessment of a tradeoff between the incremental risk that financial leverage brings and the reward of adding incremental earnings power to our business. Our analysis shows that by increasing the leverage ratio from 0.75x to 1.25x, and assuming our current yield on assets, cost of funds, operating expenses and fees, we would expect to drive an incremental return on equity of approximately 150 to 250 basis points. When we add credit losses considerations to our model, under the same assumptions, credit losses on assets would have to exceed approximately 4.0% per year before increasing financial leverages no longer accretive to return on equity. Based on our expectations for the interest rate environment, financial leverage, net asset, level yield and cost of funds, we would expect to increase the top end of our target ROE range of 10.5% to 11.5%, to 13.0% to 14.0%. We will note that this could take some time to achieve, given our selective and disciplined approach to growth.

While I don't intend to have a deep discussion about valuations across the sector on this call, we encourage those interested in this space to move beyond using book value as an anchor. Given the expected divergence in business models and financial leverage for the sector, we believe the resulting range of return on equity across the sector will be magnified without a commensurate change to book values.

As we have said before, leverage magnifies both returns and losses. With the ability to utilize greater leverage comes the responsibility of ensuring we have sound risk management processes in place to navigate noninvestment risks, such as liquidity risk, funding, market, economic loss and regulatory risk, among others. To that end, we've established a risk management committee to assist our Board in its oversight of the Company's overall risk tolerance and policies. We have posted our risk management committee charter to the Investor Resources section of our website and encourage those with questions to reach out to myself or Investor Relations soon.

As we're a year away from being in the longest economic expansion in U.S. history, our expectation is that there will be some market headwinds ahead of us given rising rates, a stronger dollar and the possibility of trade wars. We believe our focus on derisking our portfolio, opportunistic approach to liability management, and risk management practices will gear our business to perform in a downturn and maintain our ability to generate consistent shareholder returns across market cycles.

Our hope is that the shareholders recognize our track record of doing the right thing for our stakeholders as evidenced by our continued access to the capital markets and our annualized return on equity on net income since our IPO of approximately 11.4% versus our peers in the sector averaging only approximately 5%.

We remain humbled by our achievements to-date and by the ongoing support of our shareholders. With that, I'd like to thank you for your continued interest and for your time today. Operator, please open up the line for questions.

(Operator Instructions) Our first question comes from Rick Shane of JPMorgan.

Look, one of the things that you say, Josh, is that first widening of spreads since fourth quarter of 2015. Presumably you didn't wake up one morning and say, "Hey, we want better economics on the loans that we're making." And the market just followed. I'm curious what the structural change that you saw was that you think is driving this. It's certainly a positive factor, but I'm wondering what's actually contributing to it.

Yes. So Rick, I think, it's early your time, so thanks for your question. I think, I guess, 2 things. One is, is that you had a small amount of spreads widening in last quarter. And then quite frankly, some of that you've had a little bit of corresponding spread tightening this quarter. I think the volatility in credit markets or generally markets have -- are associated with a number of things, including kind of investors' lack of confidence around the political environment, around trade wars or possibility of trade wars and kind of where we are in the economic cycle. So what I would say generally as it relates to private credit markets, although things remain competitive, it doesn't feel like there's been a step function that we felt in last year as it relates to tightening spreads and the competitiveness of those markets. And so things still feel pretty stable as it relates to the competitiveness of our markets, which I think will be ultimately good for our shareholders in this space and shareholders of TSLX. That could change quickly, but there was a lot of capital formation in the space in 2017 and 2016. I think that capital formation has slowed. And I think discipline has returned a little bit. I don't know, Bo or Mike, if you have anything to add.

No, I think that's spot on. It remains a competitive environment, particularly in sponsor-related transactions, but we haven't seen the step function that we saw last year with spread tightening and term tightening. So it's a stable environment, which ultimately is a good -- a decent environment to operate in.

Our next question is from Leslie Vandegrift of Raymond James.

Just a quick question on iHeart. What was the all-in IRR? I know you had the reserve for the quarter, but just without that, what was the IRR at the end of the second quarter from that investment?

Leslie, we'll -- probably at this point, not want to talk about that publicly. It was in our expected range, given that there is litigation with the -- pending with the unsecured credit committee, which we think is meritless. And quite frankly, there's a intercreditor in place where we think we can -- even if we lose that litigation that we will ultimately recover from the junior creditors, but we'd rather not talk about that at the moment, but most definitely in the range of our expectations.

Okay. And then on the quarter, 3 of the new investments seem to be software or Business Services technology-based. Is there something particular about that sector right now that's really standing out to you guys? Seeing more deal flow from there or just better deals from there?

Yes, I guess, to-date, the largest investment we made in the space was actually not Business Services. It was Ferrellgas, which is a -- the second-largest propane distributor in the United States, which is both retail and commercial. But generally, we have a theme in Business Services. We understand those businesses well. They have high return of invested capital, high free cash flow margins at scale. Our network of sponsors kind of rely on us to provide certainty of execution in that space. So we have -- our sponsor kind of -- when we're involved, those sponsors tend to be very narrow as it relates to Business Services, Software, Healthcare, IT, Fintech given our kind of deep sector knowledge in the space. And we think those businesses have secular tailwinds and good fundamental business plans to have strong free cash flow margins and high return on invested capital. Bo or Mike?

The only other thing I'd add is, historically, as we've seen in the last cycles, they performed actually well given the very sticky highly recurring revenues that they have.

Okay. And on the leverage, now you mentioned in the release last night that you expect to be able to maintain your investment-grade ratings. And obviously, we've heard feedback from other BDCs and we've seen the S&P's comments in the past on their thoughts on the subject. I'm just curious if you've received any different feedback from them, if there is any specific commentary that led to be able to keep that?

Yes, so I think S&P actually published last night and so S&P removed the negative watch and reaffirmed a BBB-. So I would suspect that Kroll would do the same thing at their rating, which is a BBB+, and Fitch would do the same thing, which would be a BBB-. My guess is that might move from positive outlook to stable given the change in the financial leverage but there's no real core change in our investment-grade ratings across the providers. And I think S&P was out last night with reaffirming that. Ian, do you have anything to add?

No. I think it's hard for us to comment on their approach with other BDCs, but we had spent some time with them and outlined our strategy as it relates to applying lower asset coverage. And I think the commentary that they provided last night was helpful. I can forward it to you, Leslie, if that's helpful.

Perfect. I appreciate that. And then just the last question on that, your debt structures, whether your credit facility or any of your outstanding bonds and notes, do any of those have to be amended with the increase over 1.0x?

Yes. The bonds do not, the bank debt revolver will. It's hardcoded in a 200% asset coverage test. We've had significant conversations with the agent banks. We don't think that will be an issue given the nature of our portfolio and track record. And so I would suspect that we'll have more visibility in the coming months and be hopefully completed with that prior to around the shareholder vote. But I don't expect any material changes as it relates to the credit facility that would materially impact how we operate or the cost of our financings. Ian, do you have anything to add on that?

No, you covered that. That's everything...

Right. And then just a last, quick modeling question. What was the spillover income at the end of the quarter?

It's $1.06 per share is our estimate at June 30.

Our next question comes from Ryan Lynch of KBW.

I first had a couple on the leverage. One, can you talk about your leverage level maybe in the near term. You guys are kind of bumping up against the upper end of your range. Now obviously, that's going to increase August 1 of next year, potentially sooner if you guys do a shareholder vote. But are you guys comfortable going above that 0.85x leverage range in the near term?

Yes, I think I'll give you my thoughts, and I'll let Ian. The answer is no. We were comfortable this quarter as it relates to iHeart given that we had very good clarity into the prepayment. So the answer is no. I think at quarter-end, our leverage was 0.82x. And obviously, things move around our portfolio. The hope is, is that we would get the regulatory relief, which would provide the headroom at relatively short order in a shareholder vote. If we are given opportunities for our shareholders to invest in high risk-adjusted return assets, if we're above that 0.85x prior to that shareholder vote, I would suspect we would do like we always do, which was raise just-in-time equity that is accretive to shareholders in a book value basis and an ROE basis, being mindful that, quite frankly, the objective is to add financial leverage -- responsible financial leverage to the book over time to drive ROEs, and the question is kind of does the timing line up, given the opportunity set. But I think there was no current plans to raise equity given that we're in kind of the middle of our stated range. But given there was no certainty we'll get a shareholder vote, and August 1, 2019, is a long way off, exactly a year, I think, is that we would -- we obviously don't want to create existential risk for shareholders given that we mark-to-market our book on a fair value basis, including credit spreads that we erode our buffers to the current regulatory leverage on it. Ian, anything to add there?

I would just add, Ryan, given the size of the iHeart position, its impact on our leverage ratio was a little over 10 turns. So 0.11 was the impact on leverage, and so managing that through Q2 is important. We knew it was coming off with the time frame in June. So as a result, our average leverage appears higher for the quarter, but the exit towards the end of the quarter brought us back into our range.

Okay. That's helpful. And then as far as funding for the additional leverage, whenever that gets approved, do you guys see any change in sort of the funding mix you guys have right now, about half of your leverage currently funded with credit facility debt and about half with unsecured bonds as you guys get -- as you guys pass the increased leverage and start adding on more balance sheet leverage, you see any shift towards more unsecured? Or are you just pretty comfortable with the current mix you guys have today?

I think it's current mix of the long term. I think given the nature of our portfolio, we'll have the flexibility to be opportunistic in our funding mix. That's the great thing about us running the portfolio running with high attachment points, and our issuers' capital structure and low detachment point. But I think the average debt to equity is like 4.4x or 4.5x in our portfolio. And given the senior nature of our portfolio, I don't think we're going to be constrained on our secured revolver. So we'll be able to continue, and we have a lot of capacity. We'll be able to be continue -- we'll continue to be opportunistic about when we access that capital markets if it's straight unsecured or the convert market, where we think it's good for shareholders. So I think that is one of the positive things. If you were running a junior portfolio and trying to have leverage, my guess is the banks would struggle to provide that capital and force you to access it through higher cost capital and take away your ability to be opportunistic. So I think that's one of the positives about our strategy. Ian?

I'd just add the normal cadence of the business from June 30 is as we experience net growth, we'll see the funding mix naturally shift a little bit towards the secured revolver, but as we get payoffs, those payoffs go immediately to pay down the secured financing. So there is a little bit of flex, but I think where we ended June 30 was a pretty good indication.

That makes sense. And then a question on just investment hold sizes. You guys, obviously, did Ferrellgas this quarter. That's about 4.2% of your portfolio, about $80 million investment. The total size of that investment, depending, I guess, on how much is drawn, I guess, could be up to $575 million. So you guys clearly syndicated off or put it in other funds but did not hold as much as you could. iHeart, for example, was about 6.2% of your portfolio. So that was a larger investment you guys held on, on your balance sheet versus Ferrellgas. I'm just curious, how was the decision made to hold the 4.2% of your portfolio in Ferrellgas when you guys held more in iHeart for that company specifically? And then maybe even broadly, how do you just kind of balance the tension of wanting to put as much as you can of really good investments on your balance sheet but then also being mindful of some of those concentration risks?

Yes. So by the way, this was a lengthy discussion on our boards yesterday. So look, iHeart -- the interesting thing about iHeart for us was iHeart was a -- there was a strong secondary source of repayment, so we felt on iHeart that there was little possibility that iHeart which has a $1.1 billion of EBITDA actually liquidates, but in the event it does, we actually our collateral was very short duration accounts receivable from high-quality issuers, so the probability of loss was 0 in our minds in iHeart. And so that seemed to be a -- where we can have an outsized position. As on Ferrellgas, Ferrellgas's publicly traded. The -- our exposure, we do hold a little of a second-out revolver in Ferrellgas. So what you see is just a funded term loan, so our commitment to Ferrellgas in total is $112 million, which is basically consistent with iHeart. I don't think you ever see that fund, but it is consistent. We're about, if you look at Ferrellgas's capital structure, you look at the market value with enterprise of the company, we're about 20% loan-to-value or something like that where the market value of the company, I think, is 9.5 to 10x EBITDA, and right now, we're at 1.7x EBITDA, but it's a low working capital, kind of. So it is -- they're pretty comparable actually position sizes when you include the unfunded amount. I think that was -- we think those are really high-quality investments. We're cognizant of concentration risk. Quite frankly, as we increase leverage, we're going to add diversity to our portfolio. And those were, quite frankly, kind of the top end of the range as it relates what we -- feel comfortable today as it relates to the net asset value of our business.

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

Just to kind of be clear, continuing Ryan's question. The increased diversification you're outlining that will come with leverage, you will see similar hold sizes continue to run course and diversification naturally come through. Is that right?

I don't think -- so I don't think you can see similar hold sizes as it relates to net asset value and have diversification. So I think what you'll see is that, if you hold net asset value constant, you will, which we're saying outside -- which we're saying is the most likely case because we're going to add -- you can't look at -- I don't think you can look at -- let's start from the basics, which I don't think you can look at concentration on a portfolio basis. You have to look at it as it relates to your net asset value or equity capital, right, your at-risk capital. And so if we're holding net asset value constant because we're adding financial leverage to the business, I think what you'll find is, is that the average hold position as it relates to our net asset value on average will go down. And by the way, before you hop into your next question, Fin, welcome to the rodeo, so to speak. Congrats. And to your old colleague, Jonathan Bock, I wanted to take a quick second to thank him for his efforts. We didn't always agree, but he was most definitely a thought leader. We agreed more often than not, and his passion pushed the sector to examine itself and focus on its intellectual and physical capital for the benefit of our collective master, which is our shareholders. So I hope we will continue in that footstep. And it reminds me of a little bit of a Teddy Roosevelt quote, which is, the man in the arena. And no offense to any of the analyst in our calls, they have their own arena, but Jonathan, if you hear this, welcome to the arena versus being a critic, and we wish you the best of luck.

I'll make sure he hears that and try to continue with my questions here. Small one on Rex. I don't think we've got many on that one today. Is -- are your loans rolling up into the new first lien? And do the economics change at all? I think you said that it's not clearly going to be repaid immediately, perhaps by year-end-or-so -- but any outlook on the new DIP that was just approved?

Yes. So just to be clear, so the existing first-lien loan, which was about $261 million collectively and the associated prepayment penalty, which was about $45 million, I think, got rolled up into a debtor-in-possession financing with a new $100 million commitment to finance the case. There was -- the economics really didn't change on the collective of the loans. The prepayment penalty was earned this quarter, although per the kind of the restructuring support agreement, the company was put up in an auction where the DIP lenders had backstopped through a credit bid. That auction -- was the qualified bids were due last week. We did not -- although a prepayment penalty was earned. We put a reserve against a portion of that prepayment penalty given that we didn't have clarity of the bids until last week. We would expect that we will be repaid in full and were opportunistic given our understanding of the process, we will be paid in full with our yield maintenance and taken out of Rex within this year.

That's certainly plenty of color. I'll do one more, just a higher-level question. As to the pipeline of these -- a lot of your latest endeavors have made these larger, let's say, non-pass or classified deals, how do you feel about the backlog of the iHeart and the Ferrellgas's in light of financial reform or just the regulatory backdrop in general and its impact on, say, what banks are willing to hold and work through?

Yes. So I don't think -- we haven't heard -- look, the leveraged lending guidelines on new issue credit might change a little bit but not significantly. I don't think the Shared National Credit system on criticized assets -- special-mention assets, is significantly changing. We like, generally, one of our niches has been provide -- on companies that have total leverage issues, but have good fundamental businesses, providing credit on top of the capital structure in situations. We like doing that. It's very opportunistic in nature. I don't think that opportunity set is secularly changing given the regulatory environment, but those were very opportunistic in nature, and we do them, Northern Oil and Gas probably goes into that example, which is, quite frankly, delevered and performed very, very well. And so we tend to do this often, but I don't think there's a massive change in the regulatory environment as it relates to Shared National Credit.

Our next question comes from Terry Ma of Barclays.

You kind of talked about incremental leverage still being accretive to ROEs up to 4% credit losses. Can you maybe just give us a sense of what kind of credit environment we would need to see for your portfolio to see 4% losses?

Well, I would hope we don't see 4% losses. I mean, I think you clearly saw that environment in a global financial crisis, and I'm probably about the most negative human being that -- or one of them that walks the earth. I don't think you have the same recipe for systemic risk given how deleveraged banks are pre- and post-crisis. And so obviously, all that leverage moved from banks into -- quite frankly, to our grandchildren and children and through national debt. And so, I don't think you have that same recipe. You surely saw that environment in the global financial crisis. I think illustratively and quite frankly, you're seeing some of that, obviously, in the sector outside. So for us, I would hope that I think the point was to illustrate that, given that we've been running kind of in a net capital gains position, I think that the point was is that we would have to see a massive step change in our credit performance where the additional leverage is no longer accretive to the earnings power of the business. And so, I think we sent around or published a chart last night that kind of lays out the math for people, but obviously, leverage magnifies returns and magnifies losses. It doesn't start magnifying losses until about 4% annual credit losses, for us, given our asset yields and cost of financing and fee structure.

Right. Got it. That's helpful. And then just from a policy perspective, does the extra cushion from expanded leverage change the way you think about the need to issue equity below NAV?

That's a great question. The answer is probably yes and that, as you rightfully point out, is that the cushion massively changes. The -- we haven't thought through, quite frankly, given the cadence of -- but the -- I think the only opportunity again would be the same lens would be -- as surely the need to raise equity below net asset value to protect against the asset coverage ratio is diminished. The need to raise equity below net asset value where you think you could do something massively accretive for shareholders, given the opportunities that it may or may not have, and we surely have to balance that against our financial policy and keeping our investment-grade ratings through the cycle. And so quite frankly, that was -- that's tomorrow's business for the board given the vote and the cadence of the choices we have made.

Our next question comes from Chris York of JMP Securities.

So given the increased ROE outlook, the 13%, 14% provided under the SBCAA, and then your updated target leverage, should our master, shareholders, expect any tweaks to your supplemental dividend policy as you expand leverage?

Yes, it's a good question. First of all, I think, that it's going to take a long time or relatively long time to get to the new -- given our disciplined approach to adding assets, to get to the new financial target -- to get to the new financial target leverage range. So that's one thing. But you rightfully point out, I don't think the construct materially changes, which is we will set our dividend policy -- our fixed dividend policy and -- where we think we can earn it in a 3 standard deviation event, and we will pay half of the excess over time. So I don't think that changes. But as you -- as we leg in the leverage, will we increase as small amounts of fixed dividend rate given our policy, the answer is possibly, but we will have to feel comfortable that we can earn that in the 3 standard deviations because we treated our dividend as a liability, so I -- there are no changes in the near term given that it will take a while to leg into the new target financial leverage to increase our -- or the fixed rate portion of our dividend policy, but the core construct will remain the same. That being said, I think it's working pretty well for shareholders. If you look back and look at book value at 12 months ago, that dividends, and both the supplemental plus the fixed dividend has been a dividend yield of book value of above 11%. And we've actually grown net asset value over that period as well. So I think it's working pretty well, although, it surely didn't feel like that in the first half of the year given what happens to the stock. But I think, fundamentally, it's working pretty well. No core change in the policy as we grow in our financial leverage, minor tweaks around the fixed dividend rate.

Very helpful. Let's see. Staying on that similar line on expanding leverage. So do you expect any challenges rounding up investors and getting a quorum at the special meeting to vote on the lower asset coverage?

I don't expect -- I mean, look, we I don't expect -- Ian can answer this because -- and Lucy. I don't expect any challenges given that we've been able to line up quorums for special meetings in the past. And we've been able to -- we've never had any issue with quorum as it relates to our annual meeting. So the good news is that we have a large institutional shareholder base that we would like to think that we have good relationships with. So I don't think there'll be any issues related to a quorum. Obviously, I think we, as management and the affiliated shareholders count towards that quorum. And we own about 4.5% of stock. And so I don't there's -- will there be any issues. Ian or Lucy?

No. Nothing more.

I didn't there would be, but I know some other have. So I thought I'd ask the question. At quarter-end, your total assets are close to $2 billion. And you've shown an ability to originate very well above your hold. And then presumably, you considered the reduction in asset coverage with the long-term growth potential at the BDC. So maybe Josh, can you share any thoughts on the ideal asset size for the BDC, where you still feel you can maintain your competitive BDC advantages like embedded economics, nimble portfolio construction?

Yes. I think we've always said somewhere between $2 billion and $3 million or $2 billion to $3.5 billion, depending on the opportunities set -- the challenge with managing a BDC is you got to be long only and fully invested. And so the -- there will be points in time where the opportunity set is big, and you will be able to have step functions growing that. But in a competitive environment that we are in today and given the nature that it's our shareholders' permanent capital, I think, that it's somewhere between $2.5 million to $3 billion. And you might see step functions to grow that over time. And then you might -- if you can't invest in the style that we want to, we may have to return it, but I think -- that's how we think about it, and that's how we thought about it for since we started the business.

Perfect. Great. Bo, you talked a little bit about documentation in your prepared remarks and investors commonly hear about covenant-lite being done for leverage loans. But structural deterioration can surface in multiple forms such as cash flow sweeps and certain addbacks. So maybe Bo or Josh, my question to you is, are there -- is there one weakening structural protection that gives you more concern today than in the past that could lead to lower recovery on middle market loans going forward?

No. As we've stated before, we haven't seen a step function over the last few quarters in documentation standards that we saw the beginning of last year. That being said, there's definitely a loosening of standards -- the trend line over the last 3 to 5 years. It's something to watch out for. We continue to focus on thematic originations, where we're competing on things other than just price and structure, where we're thought as thought leaders and our ability to execute is at a premium. So we continue to focus on those structural protections that we believe preserve capital. I think if you follow the broader market, especially sponsor finance, there has been deterioration over the long run, though we haven't seen a step function of late.

Our next question comes from Christopher Testa of National Securities.

Josh, just on the 4% loss rate that you cited that you would need to basically have as a breakpoint before the excess leverage would not make sense. Does that type of scenario assume that spreads remain flat? Or are you also assuming a more favorable reinvestment environment can come and it wouldn't be the increase in loss rates?

Yes. Chris, you're exactly right. It's a conservative view which spreads remain flat. If the market is experiencing, call 8% default rates and 4% losses, your reinvestment levels are a lot higher and therefore, the breakpoint's different, and so that was a conservative view, which is current spread environment is something idiosyncratic with our book, but your point is exactly right, which is an environment where the market is experiencing 8% default rates, 4% loss rates, credit spreads are much wider, and your reinvestment spreads are much wider, and so you have net interest margin expansion that changes that breakpoint. That's -- I assume, that's your point?

Yes, that's exactly it. So realistically, you guys are holding the model conservatively. But if we assume that the defaults were up from a broader market trend of defaults, it would actually -- that breakpoint would be likely be higher because you'd be getting better yields on your investments?

Right. It assumes that we do something stupid, I mean, quite frankly.

Yes, that makes sense.

It's idiosyncratic of our stupidity in this.

Got it. And so I know there was -- you guys mentioned at the beginning of the call and we've seen those kind of slide back up in yields in a broadly syndicated market that have kind of come back in and then come back out. There's been a little bit of better terms and things like that going on. Josh, do you see this as something that's kind of foreshadowing something? Do you expect this to kind of pick up some momentum and snowball? Or do you think that there's just simply too much money sloshing around for us to have any sustained kind of lender-friendly environment going forward the next couple quarters?

Unfortunately, I think -- our base case is that the competitive environment has no step function change for the worse. I don't think we see a step function change for the better. I think there is a decent amount of capital formation. Unfortunately, the private credit market always doesn't look at relative value. And so we have the combination of a decent amount of capital formation plus the fundamental U.S. economy is actually doing well. And it's going to -- so if it's going to continue to do well until there's an event which is rising rates I -- you'll see that as -- I think you see inflation -- you see wage inflation, and so -- I think we're kind of stuck in the mud as it relates to volatility for the moment, which is -- you may have some small blips but nothing really sustained given the fundamentals of the U.S. economy are in decent shape and there's a decent amount of capital formation.

Got it. And just sticking with kind of a broad theme. You had mentioned obviously one of the risks of the economy being the potential for a trade war and protectionism, and I'm just curious what discussions you've had, if any, with your portfolio companies and whether they're expressing similar concerns and whether they've kind of giving you some consensus of what you think the likelihood is that there is some type of full-fledged trade wars that impact some of the portfolio companies.

The answer is not in our portfolio. Quite frankly, you surely have seen it in a broader kind of -- and broader credit portfolios. And you're seeing some earnings -- mixed earnings a little bit. And you hear it from CEOs, but quite frankly, in the software kind of Business Services, you don't have kind of those same issues as -- and so they're not as vulnerable to the trade war. So the book is pretty defensive in nature where we don't have auto suppliers. We don't have metal. We don't have aluminum. We don't have things that are -- we don't have hardware technology. We don't have things that are kind of right in the eye of the tornado there.

Got it. Okay, that's helpful. And I'm just curious. I know you generally don't get asked about this much. You have 4 companies in the portfolio, roughly $200 million total exposure just to Education. That's been something that a lot of your peers have kind of struggled with, with credit quality. Just curious what your thoughts are on that part of the portfolio and if there's an opportunity there that you guys are able to underwrite better than your peers like you do in a few other sectors.

Yes. So by the way, I'm scared to death of for-profit education, and so this is typically IT or software or business services into the education market. And Bo can go into that investment thesis, but this is -- for-profit education has scared me for the last 10 years for a variety of reasons, including the funding risk, including, quite frankly, the value-add quality to society. And so Bo, you should talk about the -- our Education thesis, which is mostly around schools have been late adopters, that there's high return on -- high return on invested capital on the purchase of software for schools. Sticky, you should go into -- but they're not-for-profit education.

This is a subtheme within the Business Services sector that we've been pursuing over the last couple years. And our thesis was -- which is proving out and that is technology adoption, particularly around how curriculum is delivered to students and how that's measured and how human capital is measured, within K-12 schools is a very late adopter, 10-plus years behind the technology curve in a lot of the industries. It also has a very sticky, deeply embedded customer base that you see very little volatility through the cycle, so it's noncorrelated. So this has been a particular area of focus for us as the return on capital in the unit economics in these businesses are very strong, and that earnings potential and earnings power of the businesses are very, very strong. So that's what we've been pursuing.

But I don't think we can do for-profit education better. It's a tough space.

Absolutely. And that's kind of been demonstrated by the loss rates for people that have lent into that.

Great. So I think that was the last question. Look, we really appreciate people's time and effort. I know that we're going through a little bit of the financial policy change, which we think is good for all stakeholders. It is a real change to our business model.

And so please feel free to reach out to the team to discuss, and I will be happy to walk you through that. Our thoughts -- and that goes for all of our stakeholders, including bondholders, et cetera. I wish everybody a great last part of the summer. And happy Labor Day. And hopefully, they get time to enjoy with their family, and we thank people again for their efforts.

Ladies and gentlemen, thank you for participating in today's conference. This does conclude the program, and you may all disconnect. Everyone, have a great day.