Sixth Street Specialty Lending Inc (TSLX) 2018 Q3 法說會逐字稿

Good morning, and welcome to TPG Specialty Lending, Inc.'s, September 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 statements.

Yesterday after the market closed, the Company issued its earnings press release for the third quarter ended September 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 third quarter ended September 30, 2018. As a reminder, this conference 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 and my partner, Bo Stanley, to discuss our originations and portfolio metrics for the third quarter. Our CFO, Ian Simmonds, will review our financial results in more detail, and I will conclude with our final remarks before opening the call to Q&A.

After market closed yesterday, we reported strong third quarter financial results, with net investment income per share of $0.50 and net income per share of $0.57, both which exceed our third quarter base dividend per share of $0.39. Our Q3 results imply an annualized return on equity on net investment income and net income of 12.2% and 14.1%, respectively.

Reported net asset value per share at quarter end was $16.47, an increase of $0.19 compared to the prior quarter after giving effect to the impact of the Q2 supplemental dividend, which was paid during Q3. Net asset value movement during Q3 was primarily driven by the over-earning of our base dividend, the positive impact of net unrealized gains specific to certain portfolio companies, and tightening of credit spreads quarter-over-quarter.

Yesterday, our board announced a fourth quarter dividend of $0.39 per share to shareholders of record as of December 14, payable on January 15. Our board also declared a Q3 supplemental dividend of $0.05 per share to shareholders of record on November 30, payable December 31.

Over the trailing 12-month period, we declared a total of $0.22 in supplemental dividends, while increasing net asset value per share pro forma for the impact of the supplement dividends from $16.03 to $16.42. This represents an increase in total dividends declared over the base dividend level of 14.1% and an increase of net asset value per share of 2.4% over the same period.

We continue to assess the appropriateness of our base dividend level in context of the underlying earnings power of our business to ensure we're optimizing cash distributions and satisfying RIC requirements, while preserving the stability of net asset value.

Post quarter end, we received shareholder approval to reduce our minimum asset coverage ratio from 200% to 150%, or to say it another way, to increase our maximum debt-to-equity limit from 1x to 2x. Of the TSLX shareholders who voted, approximately 99% voted in favor of the proposal. We are humbled by the continued support of our shareholder base.

As announced yesterday, we've also completed all necessary amendments to our revolving credit facility to allow us access to regulatory relief provided by the Small Business Credit Availability Act. Ian will discuss this in more detail. We believe regulatory relief provided through a reduced asset coverage requirement is beneficial for all of our stakeholders. Investment environment permitting, we will look to use incremental leverage through modestly revised financial policy to drive incremental return on equity for our shareholders.

On the portfolio side, let me provide an update on 2 names highlighted in our last call, iHeart and Rex Energy. You may recall that we had made specific income reserves in Q2 related to these 2 investments totaling approximately $0.06 per share, given the lack of visibility at the time on bankruptcy-related outcomes. During the quarter, upon completion of Rex's asset sale to a strategic buyer, we received full cash payment of our debtor-in-possession loan along with accrued interest and fees earned in Q2 upon the company's Chapter 11 filing. As a result, we released $2.875 million of reserves established in the prior quarter into this quarter's income.

On iHeart, recall that we reserved $592,000 of certain interest income we received during Q2 in connection with the repayment of our loan principle upon the funding of the company's new debtor-in-possession financing. We created this reserve as a result of an objection filed by iHeart's unsecured creditors committee in July on certain portions of our income received by the ABL lenders. The UCC now supports a plan of reorganization that removes this prior objection to the ABL claims, and we expect to release this income reserve during the fourth quarter.

On October 15, one of our ABL portfolio companies, Sears, filed voluntary petition for relief under Chapter 11 of the Bankruptcy Code. The company intends to pursue a store rationalization and a going-concern sale process for all the remaining assets. Our $17.3 million par value first lien ABL loan is expected to be rolled up in the first lien debtor-in-possession financing, which calls for mandatory repayments from the cash proceeds of asset sales. We believe our investment is well-secured by the company's working capital assets and additionally, by the company's additional real estate collateral, which was pledged. Given the milestones in the bankruptcy case, we expect to be fully repaid on our principle investment within the first half of 2019.

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 detail.

Thanks, Josh. The direct-lending environment in Q3 continued to be highly competitive. In response, we stayed focused on late-cycle capital structure and sector selection, and maintained our high degree of investment discipline.

During the third quarter, we generated gross originations of $317 million across 4 new investments and upsizes to 2 existing portfolio companies. Of the $317 million of gross originations, $175 million were allocated to affiliated funds, and $8 million consisted of unfunded commitments. On the repayments front, there were 3 full realizations totaling $119 million aggregate principle amount, resulting in net portfolio fundings of $15 million for the quarter.

We continue to be thematic in our originations approach, focusing on opportunities that correspond to our platform sector expertise and relationships. 3 out of the 4 new investments this quarter were software technology businesses that have uncorrelated revenue characteristics, high-quality customer bases, and strong returns on invested capital. While the direct-lending software technology companies have become increasingly competitive, we've been able to differentiate ourselves through our deep sector knowledge, ability to move quickly, and to make large-scale commitments given the capabilities across the TSSP platform.

One of our investment strategies continues to be opportunistic capital deployment in dislocations as a way to generate excess returns across our portfolio. Upstream E&P, one of our opportunistic themes since late 2015, has been a sector where we've been able to generate strong risk-adjusted returns, most recently with our loan investments in Rex and Northern Oil.

The Rex paydown this quarter, which Josh discussed, resulted in a gross unlevered IRR on our investment of 34%. And post quarter end, we realized on our $58.5 million par value loan investment in Northern Oil in connection with a refinancing. Since the refinancing was announced prior to quarter end, the Q3 fair value mark of our loan reflects a scenario where we would earn a make-whole premium. The net proceeds we received upon the closing of the transaction in October exceeded what was implied by our Q3 mark on the loan, resulting in a gross realized unlevered IRR on our debt investment of approximately 36%. Since inception, through September 30, we've invested approximately $340 million in the energy sector and generated a P&L of $47 million across the current and fully realized energy investments. We'll continue to be opportunistic in this sector given our platform's expertise and ability to drive high risk-adjusted returns.

Across our portfolio, since inception, through September 30, we've generated gross unlevered IRR of 18.8% on fully realized investments, totaling $3 billion of cash invested.

Turning now to our portfolio metrics and yields, at quarter end, we had effective voting control on 86% of our debt investments and an average 2.2 financial covenants per debt investment, consistent with historical levels. As for mitigating prepayment risk, the fair value of our portfolio as a percentage of call protection at quarter end was 95.8%. This metric means that we have protection in the form of additional economics should our portfolio get repaid in the near term. Our direct originations strategy has allowed us to structure meaningful downside protection features into our portfolio, despite the competitive lending environment. At quarter end, 99% of our portfolio by fair value continued to be sourced through non-intermediated channels.

At September 30, the weighted average total yield on our debt and income-producing securities at amortized cost was 11.3%, compared to 11.4% at June 30. The slight decrease was due to the impact of new versus exited debt investments.

Regarding asset mix, 94% of our investments at quarter end were first lien on a fair value basis, consistent with our defensive approach. Our portfolio is well-diversified across 49 portfolio companies and 17 industries. Our largest industry exposure continues to be business services at 19.5% of portfolio at fair value, followed by financial services at 15.6% of portfolio at fair value. Note, the vast majority of our financial services portfolio companies are B2B integrated software payment businesses with limited financial leverage and underlying bank regulatory risk. At quarter end, our cyclical exposure, excluding energy, was at an all-time low of 3.5% of the portfolio at fair value. Our energy exposure at quarter end represented 4.9% of the portfolio at fair value, or 1.3% adjusted for the paydown of the Northern Oil loan post quarter end.

From a portfolio quality perspective, there were no investments on non-accrual status at quarter end. Overall, portfolio performance has trended well quarter-over-quarter, improving from 1.24 to 1.19 based on our assessment scale of 1 to 5, with 1 being the highest.

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

Thank you, Bo. We ended the third quarter with total investments of $1.98 billion, total debt outstanding of $893 million, and net assets of $1.07 billion, or $16.47 per share, which is prior to the impact of the $0.05 per share supplemental dividend that will be paid in Q4.

As Josh mentioned, our net investment income was $0.50 per share and our net income was $0.57 per share. Average debt-to-equity during the quarter was 0.91x, compared to 0.89x in the prior quarter. Given our visibility into the late-quarter timing of certain repayments, we chose to operate at higher leverage levels during Q3 and ended the quarter with debt-to-equity of 0.83x, inside the top end of our historical target range. At quarter end, we had significant liquidity, with $483 million of undrawn revolver capacity.

In conjunction with yesterday's earnings release, we also announced an amendment to our revolving credit agreement to reduce the company's minimum asset coverage ratio covenant from 200% to 150%. This accomplishes 2 things. First, we now have access to regulatory relief provided by the SBCAA to operate with a significantly expanded regulatory limit cushion. Second, we now have flexibility to execute on our revised financial policy of 0.9x to 1.25x debt-to-equity by selectively growing assets over time and increasing the fundamental earnings power of the business. We appreciate the support from our existing lenders on this process.

In addition, Moody's Investors Services has assigned TSLX an investment grade rating of Baa3, with a stable outlook, following a review of our investment strategy, track record, capital structure and liquidity profile. We are pleased to add the Moody's rating to our existing investment grade ratings profile from S&P, Fitch and Kroll.

Moving back to our presentation materials, Slide 8 contains a NAV bridge for the quarter. Walking through the various components, we added $0.50 per share from net investment income against the base dividend of $0.39 per share. There was a $0.06 per share reduction to NAV, as we reserved 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, the marginal tightening of credit spreads led to a positive $0.08 per share impact on the valuation of our portfolio, which was partially offset by a $0.03 per share negative impact to NAV from unrealized mark-to-market losses related to interest rate swaps. "Other changes" of $0.09 per share primarily includes unrealized gains from our investment in Northern Oil that Bo referenced earlier.

As a reminder, given our risk management practice of implementing fixed to floating swaps on all of our fixed-rate liabilities to match the floating rate nature of our assets, any upward movements in the shape of the forward LIBOR curve since the inception dates of our outstanding swaps, either through a shift or through steepening, have the effect of creating unrealized mark-to-market losses. Our NAV per share at the end of Q3 included $0.14 of cumulative swap-related unrealized losses that will unwind over time as we approach the maturity date on each swap instrument.

Moving to the income statement on Slide 10, total investment income for the first quarter was $63 million, down $3.4 million from the previous quarter. Breaking down the components of income, "interest and dividend income" was $56.7 million, up $1.1 million from the previous quarter given the slight increase in the average size of our investment portfolio.

"Other fees," which consist of prepayment fees and accelerated amortization of upfront fees from unscheduled paydowns were $5.2 million for the quarter, compared to $7.6 million in the prior quarter. "Other income" was $1.2 million for the quarter, a decrease of $2.1 million from the prior quarter given syndication fees earned during Q2.

Net expenses for the quarter were $30.1 million, up from $29.2 million in the prior quarter primarily due to high interest expense. This was due to an increase in the average debt outstanding, as well as an increase in the effective LIBOR rate on our outstanding debt. Our weighted average interest rate on average debt outstanding increased by 18 basis points quarter-over-quarter, primarily due to the increase in effective LIBOR across our debt instruments. Note that "other operating expenses" this quarter includes non-recurring professional fees related to the reduction in our asset coverage requirement.

Before passing it back to Josh, I wanted to provide an update on the unit economics of our business. Year-to-date, we've generated strong annualized ROEs based on both net investment income and net income of 13.7% and 14.4%, respectively. This was the result of robust, all-in asset yields and an expansion of balance sheet leverage. Since year-end 2017, our average quarterly leverage ratio increased from 0.72x to 0.91x, and our quarterly investment income yield on average assets increased from 12% to 12.8%. Our all-in cost of debt over this period increased from 4.9% to 5.3%, largely a result of the increase in LIBOR. By maintaining our investment grade ratings profile, our hope is that the spread on our cost of debt over LIBOR does not materially increase over time.

Given our capital deployment discipline, which we believe is especially important in today's competitive and late-cycle environment, we may from time to time operate below our revised target leverage range of 0.9x to 1.25x. As we've said in the past, in periods where we see a decrease in our financial leverage, we would expect elevated levels of other fees from repayment activity to support our ROEs. We believe our revised financial policy will allow us to drive incremental ROEs for our shareholders as we reach the higher end of our leverage target, which again, could take some time to achieve given our selective and disciplined approach to growth.

At the beginning of the year, we had set our 2018 earnings guidance based on our prior target ROE range of 10.5% to 11.5%, which corresponded to a full-year NII range of $1.69 to $1.85 based on beginning pro forma NAV of $16.06 per share. Last quarter, based on year-to-date results, we updated the upper end of our full year guidance from $1.85 to $2.00 per share. Given our Q3 performance and the fee income associated with the repayment of our Northern Oil loan post quarter end, we are revising our full year NII per-share guidance to a range of $2.07 to $2.12, which implies an ROE range of 12.9% to 13.2% for 2018.

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

Thank you, Ian. We are pleased to have delivered another strong quarter resulting in incremental dividends to our shareholders. As I shared in my opening remarks, the goal of our dividend framework is to maximize distributions to our shareholders based on the underlying earnings power of our business while maintaining the stability of net asset value.

Going forward, as the market opportunity set allows us to operate with higher balance sheet leverage within our new targeted range and increase the return on equity for the business, we would look to resize our base dividend accordingly. Our practice is to set our dividend at a level where we believe we can be consistently earned over the intermediate term, and therefore, we'd only take action if we believe there's a sustainable increase in the earnings power of the business.

In periods of tight risk premiums, we believe our undrawn capital is our most valuable asset. When the market doesn't offer appropriate risk-adjusted returns, we'll be slow to deploy capital given the high opportunity costs of doing so. That is, forgoing our ability to deploy that same capital during more attractive investment environments into attractive risk-adjusted return opportunities to drive return on equity. We believe our stakeholders' support in providing us with immediate access to leverage flexibility reflects our focus on optimal capital allocation and prudent approach to growth. We continue to be long-term-oriented and work hard to deliver attractive risk-adjusted returns for our shareholders.

With that, I'd like to thank you for your continued interest and for your time today. Operator, please open the line for questions.

(Operator Instructions) And our first question comes from Rick Shane of JP Morgan.

Look, the industry is about to experience essentially an influx of liquidity, so the supply capital is going to increase. Demand for capital probably won't increase as much. As we enter that environment, it kind of feels like everybody needs to gain market share, which is, obviously, impossible. How concerned are you about pricing, and how concerned are you about the further erosion of deal terms?

Hey, Rick. It's Josh. I think we spoke at length about this. We share your concerns. Look, the industry has under-earned its cost of equity for a long, long period of time. So I think since the 4 years we've been public, the average ROE is between 5.5% and 6.5%, which, quite frankly, is under-earning its cost of equity. It's why the industry is trading below book value. So the idea that there is excess supply in the industry already -- and you can see that, because they're not earning its cost of capital -- and that you will have additional capacity, the change in the Small Business Credit Availability Act I think is deeply concerning to us. That being said, we're not focused on market share. We've never been focused on market share. We're focused on providing high risk-adjusted returns on capital to our shareholders, at the same time, protecting other stakeholders, including our creditors. So I am deeply concerned that more supply in an industry that's over-supplied and the incentives that people have operated under, which I would argue is the wrong long-term incentives, will create an environment for worse deal terms. That being said, I have 100% confidence in our ability to manage through that. And quite frankly, we've managed through that over the last 4 years given the industry's been over-supplied. So I share your concerns. I would suspect and I would hope that the industry participants would act rational and deploy capital slowly. Obviously, that hasn't always been the case, and growth is the enemy of returns for finance companies and the enemy of quality, and so we share your concern. Again, that being said, I don't share your -- I am not concerned about our ability to manage through that.

Fair enough. Look, we appreciate the discipline, and we also appreciate the -- I mean, look, you can't get it right unless you view the world in the right way, and we share your concerns about what's going to happen in the next 6 to 12 months just in terms of influx to capital. Thanks, guys, for taking our questions.

And our next question comes from Ryan Lynch with KBW.

Last week, I was reading a Wall Street Journal article, and they were talking about with some volatility in the equity markets, it actually created some volatility in the bond market, the speculative-grade bond market, and they talked about 3 recent bond sales that were recently pulled and couldn't get done. I was just wondering -- I know you guys have been very opportunistic in the past and have been able to be very creative, flexible and fast. Are you guys seeing any sort of disruption in the bond markets, and does that present any sort of opportunity for you guys to be opportunistic in that at all?

Great question. So you saw some volatility in the bond market, mostly driven by the high-yield outflows, retail outflows, and that was driven, A), by retail, and B), concern over rates, and that's a fixed-rate market. On the leveraged loan side, which is, quite frankly, less -- is more stable -- that capital base is 60% CLOs, and you did not see much volatility. You might have seen bids back off 1/8 to 3/8 on loans, but low supply, and so you haven't seen that volatility kind of move into other areas of the credit spectrum. So our hope is that you will see that. Our business model is long vol. As we talked about in my closing remarks, right, the -- our undrawn capital is our biggest asset, because that allows us to attack volatility in markets. We did that in Q4 of '15, Q1 of '16. I think at our high point, there might have been 20% of our book was in Level II names, and today it's basically zero, but you haven't seen it creep in yet. You've got to be careful what you ask for a little bit in that your long -- we're long on a whole bunch of assets, but we feel good about those assets. But we're also long on a whole bunch of dry powder. So we think we're well-positioned, but you haven't seen it yet.

And, actually, the article also talked about one of those deals that couldn't get done was the high-yield bond market, actually, was able to then move over and get done in the leveraged loan market, so that makes sense about that having the same volatility there. I wanted to talk about you guys' leverage range, the 0.9x to 1.25x. That's a pretty wide range that you guys have disclosed, and it's not unusual. Other BBCs have had a similar range. But I just wanted to kind of get more commentary on what factors you guys consider that would have you operate in the lower end of the range versus the upper end of the range. I mean, what are you looking at? Are you guys looking at the pulse of the economy, your competition, private middle-market credit, or quality and quantity of deal flow? And given those factors that you guys evaluate and where we are today, do you think it makes more sense to operate towards the lower end, the upper end, or kind of right in the middle?

So that is a super-insightful question. So, look, the range is wide. The range is wide for a reason, because we don't know what the environment is going to afford us. In an environment where you have -- where the market is offering you high risk-adjusted returns on capital, you would expect us to operate at the high end of that range. In a market where we're in today, where the -- where we think that risk-adjusted returns are fair to slightly expensive, right -- surely the market is not cheap -- you would expect us to operate at the lower end of that range. And quite frankly, it's going to take us -- even if we were constructive on the market, given that growth is the enemy of underwriting standards and process, it's going to take us a while to kind of leg into that leverage. Obviously, that leverage is a big driver of kind of the earnings power of the business, or at least a part of it, and so when you think about -- what we've told the market is you can expect ROEs -- our guidance this year was I think 10.5% to 11.5% at 0.75x to 0.85x debt-to-equity. We've done significantly better than that. If you think we're operating at 1x to 1.2x with our same asset level yields, those ROEs are significantly better than that, so call it kind of 11% to 13%, depending on credit losses, which -- well, obviously, you can back into the envelope on what EPS is by just taking those ROEs, times it by the most recent NAV, and it will get you kind of the expected range of GAAP ROE -- I mean, GAAP EPS. And so the answer is we don't know, and so it's a wait-and-see approach, and the inputs are surely where we are in the economic cycle and what is the market providing us on a risk-adjusted return basis.

And then just one last one. It sounds like you guys are maybe potentially kind of evaluating the core dividend and may do something with that in the future. I'm just kind of wondering, what are you guys looking at? I mean, you guys have significantly earned the core dividend through NII. You guys significantly over-earned the dividend through the core, plus a special dividend or variable dividend on top of that. I understand you don't want to get over your skis and raise the dividend, the core dividend, and so just what are you looking at? Are you looking at kind of your NII coverage of the core dividend, having a certain percentage above that, or are you guys looking at some sort of downside scenario if spreads compress and non-accruals increase, that we can still earn before we would potentially raise that? What are you guys kind of looking at and evaluating?

So, yes, let me tell you one of the things is -- first and foremost is we want to be RIC compliant, and so this is not an earnings estimate, but let me give you the math. At 50 basis points of credit loss, 1.25x leverage, with LIBOR curve, EPS is like $2.30 to $2.35 a share, and it -- obviously, if you have to -- assuming 90% of your income, at our formula plus our base dividend, we do not meet the RIC requirements. The math is that simple. So you could do the math, which is $2.33 minus $1.56, divided by 2, plus the $1.56, compared to $2.33 times 90%. I think we fall short. And so, obviously, the RIC compliance is a piece of it. The second piece of it is that under a stress scenario where losses increase, we want to be able to cover the core dividend and have GAAP, NI, ROEs cover the core dividend. And so that's the second piece of it. The third piece of it, which is kind of the lowest priority, but it's still a priority, is we prefer to get as much cash back to shareholders while preserving net asset value, because that's kind of the product we offer. What that does for investors is it gives them the option to reinvest in the DRIP program, which the DRIP program, they could buy shares at a discount to the price, which creates value, or they could make other investments or fund retirements, et cetera. And so it's a combination of those types of things. I think what we're signaling is in the event we're able to slowly increase financial leverage, we will have to increase our base dividend, given not only RIC, but given that the earnings power will -- given not only the RIC considerations, but that we want to optimize cash back to shareholders. And, again, don't -- the $2.33 was not an earnings estimate. The $2.33 was an extreme case to show you the RIC compliance issue that we would have borne if we did not adjust our base dividend accordingly.

And our next question comes from Mickey Schleien of Ladenburg.

Josh, just a couple of questions. We're seeing companies in the middle market doing, really, I think exceptionally well this year, and I'm interested in understanding whether -- at least in terms of your portfolio, are you seeing your EBITDA grow fast enough to sustain their fixed-charge coverage ratios as interest rates have been climbing?

Mickey, that's a good question. I think the answer is most definitely yes if you think about the world and kind of status quo continued growth. The good news is that most of our companies are business services, software. We do not have a heavy manufacturing base. We don't have input price issues regarding kind of the environment we're in, related to the trade war, and so earnings momentum has been positive. Our companies have, on average, 3x interest coverage with growing earnings. And so I think in this environment, you should continue to see -- you should continue to be constructive on credit. That being said, there are tail risks where this environment is not sustainable, including increasing interest rates, not only as it relates to increasing fixed-charge coverage, but as rates increase, hurdle rates for investments go up, which has a -- it slows the economy. Consumer spending goes down, which slows the economy. And so you clearly have tail risks, including rising rates, that impacts not only corporate credit and interest coverage, but impacts the general economic environment. I would say that's the big portion of our portfolio. Obviously, we have some -- we have carved out a little niche doing stress financings in retail. Retail comps are actually pretty good. I would expect them not to be good going into Q4 -- or comps will be okay. Margins I think will be relatively poor given they won't be able to pass on price increases, given -- and that they will have issues with wage inflation. I think the bottom decile worker is getting most of the wage gains, which are seasonal workers for retail. So I would expect -- as you know, we underwrite that portfolio on a liquidation basis, so we feel very good about the underlying credit quality of that portfolio, although I would expect to see some pressure on retail earnings in Q4 and going forward. And so I just wanted to kind of bifurcate our book between kind of the performing stuff versus the stress stuff, and the stress stuff where we underwrite to some type of event or a secondary source of repayment based on asset value, they will probably continue to have some issues on the earnings side.

And in terms of a tail risk, it's been a long time since we've seen the Fed go through a tightening cycle, and some folks would argue that there was too much tightening last time and that precipitated or helped precipitate the downturn. So now we're in a new tightening cycle, and I'm interested in understanding when you underwrite your deals, particularly second liens -- and I know you don't do a lot of second liens, but how much stress do you assume in EBITDA and in those fixed-charge coverage ratios to make you comfortable going into what appears to be late in the cycle?

Yes, that's predominantly why we don't do second liens. So it's -- look, generally -- not generally. We always use the LIBOR curve as it relates to when we underwrite our investments. We also, obviously, stress earning powers of the business, both growth -- depending on what the key drivers of the business are, wage inflation on the cost side, so we sensitize the gross margins, EBITDA margins and sales. The challenge is, given that you are financing relatively high earnings compared to the trough at peak leverage ratios, it's led us to not allocate capital to second liens for that exact reason. The 2 updates that I would give you as it relates to our second lien book, one in public, AFS, which we owned equity, owned effectively the business and had a second lien, was recently sold/recapitalized. We kept a small piece of the common equity to -- and we sold that to a private equity sponsor basically at our mark, called Symphony. We now -- we continue to finance that basis on a first line basis, so we've moved up the capital structure. And my guess is that Vertellus at some point, which is our other second lien, will actually refi as well in short order. So we continue -- that's not saying we'll never do a second lien. We look at them on good businesses depending on the attachment point and how strong we think the earnings power of the business is, both on a secular basis and to withstand cyclical headwinds. You could see us participate -- I can tell you our second liens are basically going to be at 0, so you can't get less than 0. But we continually try to move up the capital structure given where we are on a risk-adjusted return basis, late cycle earnings and peak leverage.

And our next question comes from Leslie Vandergrift of Raymond James.

Quick question on the Moody's upgrade. That upgrade this morning had very good wording in it talking about the portfolio and security, similar to the S&P one a couple months ago, I guess, now. But given that you now have Moody's and S&P on the investment grade, as well as others, do you feel that your debt cost of capital going forward could get cheaper?

I'll let Ian answer. What I'll say is I'll clarify it wasn't really an upgrade. It was an initiation, so we weren't covered by Moody's originally. But I'll let Ian give you a little color on the Moody's.

I think part of the strategy was how do we go about expanding the universe of investors that we can speak to on the investment grade side. Moody's, obviously, comes with a certain perception in the marketplace, and so the first part of it was how do we get a broader investor universe, and then if that allows us to help keep our funding costs down, then that would be a good byproduct of having attracted those net broader universe.

Ian, that's exactly right. The only thing I would add is that -- I think people know this, and it's not going to be a surprise, which is the fixed-income market for BDCs is relatively shallow, and for whatever reason, that includes partly because Moody's hasn't probably been constructive on it given that they thought the biggest constraint was the lack of regulatory cushion, and so our belief is that if we can continue to create optionality and continue to validate the space and broaden the rating agency's support, that that market, over time, will get less shallow -- I'm not sure it will ever be deep, but less shallow, although I think -- generally, I think that market for the ratings provides very good risk-adjusted returns, but it will be less shallow and that we will get longer-term funding where that is beneficial not only to the sector, but to TSLX.

And on fee income in the quarter, you talked about in the prepared remarks it was a little bit lower quarter-over-quarter because it tends to be lumpy there, but the $2.88 million from Rex, that was in top line interest income, correct?

Yes.

And then for the fourth quarter outlook so far on the fee income broken out line, given Northern Oil and any other outlook you have for the quarter, do you think that's going to be kind of run rate like this quarter or one of the higher quarters again?

I'm sorry, Leslie, I lost the question.

I think the question was Northern Oil --

Oh, sorry. The fourth quarter outlook for fees, yes.

Fourth quarter outlook for prepayment fees. So there's a large prepayment fee on Northern Oil. That position was marked at, I'll use estimates, but that position was marked at 113 at quarter end, which was, Ian, how much in equated dollar -- I'll just use 113. We ended up collecting more than the price, and so you can impute that there will be a decent amount of prepayment income in Q3 -- I mean, Q4. As Ian said, I think our estimates for Q4, if you just isolate Q4 on an NII basis, are between, Ian, $0.50 and $0.55?

That's right.

And Vertellus -- last quarter, the first thing was marked as due in August of this year, and now it's marked as due in October of this year. Is there an update there?

Yes. So there is basically committed financing that we are not going to participate in, but it was slow to close, and so the existing bank group did a 1- or 2-month extension to facilitate that committed financing. But there is committed financing provided by a backstop of existing lenders. We had the option to actually put our existing position to the backstop parties. We decided not to do that, because why not -- knowing that it's committed, why not collect the extra interest income?

And on Ferrellgas, the largest investment right now in the portfolio, was marked up in the quarter, and I just was looking for an update on that investment.

I think Ferrell -- let me give you an exact number. I think Ferrell was relatively -- maybe because it's a large position, but on a price -- sorry. Okay, it was marked from -- sorry. Ferrell was marked up a quarter basis point, I think, so the 6/30 mark was a 100.25 quarter. The 9/30 mark was a 100.50. So that's a reflection of where other parts of the capital -- the discount rate and where other parts of the capital structure trade. The company continues to perform as expected. And, quite frankly, there was a small change in market spreads quarter-over-quarter as well.

And lastly, just a modeling question. What was the spillover income level, again?

Sure, Leslie. It's $1.01 per share.

And our next question comes from Chris York of JMP Securities.

So just a couple of modeling questions. How much professional fees were nonrecurring as a result of the pursuit of the SBCAA?

Chris, great question. Ian will dive into that. The SBCAA was expensive this quarter between the special meeting and rating agencies. Ian will dive into that.

I would use a number of about $500,000, Chris, and that's a combination of legal fees we paid for a solicitation agent on the special meeting, and we had some incremental fees from rating agencies. So $500,000 is a good estimate for the nonrecurring element out of that.

A cheap price for regulatory relief, but good question, Chris.

And then you also have some nice equity appreciation on a couple of portfolio companies where you have co-investments, so while I presume your ability to influence monetizations are limited, are there any investments that appear more likely to result in any near-term exits?

Look, we surely control NOG, because that's public equity post us comfortable selling on an MNPI basis that we're cleansed, so we clearly can control that. And then I think the largest one probably is Swift, which is a neat little company that's doing very, very well. We have a co-invest. We have the typical rights, including preemptive rights, but we don't control the monetization of that. But the company has done very well, and so we don't really have a view. It wouldn't be my place to speculate.

But if you did exit NOG or Swift there or any other company at a realized gain, how would this income affect your thinking on dividend distributions and then being in compliant?

I don't think it would. I don't think they're material enough to change the -- change our distribution policy. I think what's more material as it relates to our distribution policy is what we think the core earnings of the business is, and so I don't think those materially change the policy, and surely don't -- are not material to make it compliant versus non-compliant.

And then shifting maybe to Josh or Bo, so you've been lending to SaaS and software companies for a long time, and in this quarter, you had some origination activity skewed there, but I think I've noticed a fair amount of expansion in lending to software companies from other large alternative asset managers, so the question is two-fold. 1), have you noticed any marginal competition and/or deterioration in the quality of deal flow, and then, 2), what does the pipeline look like for your SaaS or software companies?

Bo.

Sure, I'll take that.

And Fishman can add to it too.

Exactly. I think for sure there's been an increase of competition in the space over the last 2 to 3 years as people move into these assets that they believe are more resilient than some of the manufacturing-based cyclical businesses, so we've certainly seen an influx. I think for us, having been a long-term investor in the space, 20-plus years if you count our partner, Mike Fishman, who's on the call with us and can add some color as well -- we continue just to be thematic within technology originations and focus on areas there where we see strong secular growth within technology and software, and where business models aren't as understood and we can actually provide value and insight to those processes and, with exemptive relief, provide a balance sheet and certainly in transactions. So the competitive environment has increased. I think our opportunity set has remained pretty solid, and we continue to see opportunities in the space, and in this quarter, we're seeing that as well. Mike, do you want to add anything?

I mean, just going back to what Josh said, I mean, we've been -- we're not interested in market share, even in this segment, so we see a fair amount of opportunities and we just continue to be selective, in part because what you said is true, which is there is increased competition in the space, and the risk returns we're seeing on a number of investments that we're looking at just don't hurdle for us. So we continue to expect to do -- to make investments in this space, but be much more selective.

And then, I mean, staying on the topic, with expansion leverage and then potential for a bigger balance sheet and, therefore, lending to larger companies, could you use your software and your expertise in that area to lend to public companies when maybe the broadly syndicated market gets disrupted?

So, Chris, I would not draw a line between bigger balance sheet and lending to bigger companies. I mean, look, our strategy has always been try to stay right under -- and there are always exceptions, NOG, Ferrell, where there are some idiosyncratic things happening in that business, but we'll stay right under where the broadly syndicated market or the leveraged loan market operate. We think those are very efficient mediums of capital for companies who have access to it. And so I don't -- if we are in this same environment and without massive volatility, I don't think our core portfolio changes, and I don't think we start doing massively bigger deals and with bigger companies given I think those companies have access to much cheaper capital in the CLO market and the high-yield market. That being said, where you will see us move up-market is -- today, our average EBITDA is slightly moved up. The core EBITDA of our book is about $37.5 million, and so it's slightly moved up, but if you look back in 2013, when the markets were closed, the weighted average EBITDA was like $42 million and new investments were like $60 million. And so what I do think is as you see volatility in the high-yield market and/or leveraged loan market shut down, you will see us clearly go up-market.

And then last year -- pivoting a little bit on the topic of second liens, have you had to turn off any distributions to any obligors in your investment portfolio to second lien lenders that may be behind your position today?

That's a good question. So the answer is no. We've seen some -- we have a JV outside of TSLX and our private credit fund with CIT. We have -- and that's a senior lending portfolio, but it's a LIBOR 400 book. It's not appropriate for TSLX. We have seen some payment blockage as it relates to sub-debt of negotiated second lien payments being deferred. Those companies tend to be more manufacturing-oriented and having some gross margin issues or inflation -- or wage inflation issues, but we have not seen that in our book. If you look at, for example, Ferrellgas, which is publicly traded, has unsecured bonds -- none of those are subordinated. We don't have payment blockage rights, but Ferrell's free cash -- and our perspective is levered free cash flow neutral to positive, with a lot of liquidity, and so the company is very well-positioned to service its debt. And so we -- I have not seen -- there's not an instance in the TSLX book. We've seen a couple instances in our broader kind of credit book or senior lender, but nothing in the TSLX books.

Great. That's it for me. Thanks for taking my questions, and congrats on the good quarter.

Great. Thanks.

Thanks, Chris.

And our next question comes from Christopher Testa of National Securities.

I just wanted to talk about you guys discussing, obviously, the reduced asset coverage and increasing the size of the balance sheet. Have you guys evaluated the securitization market instead of potentially raising the revolver capacity or issuing another bond?

Let me start, let me frame it, and then Ian will hop in. So the answer is all capital markets transactions are on the table. Our preference would be the straight bond market. Outside of -- our first preference is, obviously, increasing the revolver. That revolver has our lowest funding costs. We've committed to have a funding mix between secured and unsecured. And so if you think about it on an unsecured basis, we think our preference would be the straight unsecured market. The convert market may or may not be attractive over periods of time. What I would say is that when you look at generally the convert market, it's been 98% bond math for BDCs and convert investors. That has been -- it's worked because there have been -- the convert market basically had priced that paper looking at historical vol, which coming out of the crisis was higher than forward vol, which provided BDCs to access a cheaper capital. Today, going forward, my guess is vol in the space, if you think there's going to be increased earnings power, is actually going to be higher than kind of the 10% to 15% vol, where it is now, and so that makes it probably less attractive on the margin. Again, if you look at our convert on our 22s, it's -- what's the strike price, Ian?

Effectively, now it's $20.96, less the supplemental today, so $20.91.

$20.91, and so that paper is going to be -- if we are able to increase financial leverage and continue to control credit costs, that is going to -- there's a lot of value in that option. Quite frankly, when we originally did that deal, we didn't think there was value in that option or as much value as there is. And so given our view on core earnings power of the business going forward, that would probably be lower on the list. As it relates to the securitization market, the pluses and minuses of that market is, A), it's secured financing. It's not as attractive as secured financing as our secured revolver. Although it's termed financing, the weighted average life tends to be shorter than you think it is, which when you think about the upfront costs, it increases the actual cost over what appears on a spread basis when you execute those liabilities. So revolver, unsecured, convert, securitization probably is the order, but we're open. We're opportunistic. The good news is we have $450 million of liquidity, so we're able to, with no near-term maturities -- the nearest maturity is the '19s, which is $115, and so we're able to be opportunistic. I'm now sitting here thinking to myself, oh, my God, I took everything from Ian, but I don't know if you have anything more to add.

Nothing more to add.

And just touching on your comment, too, on potentially raising the dividend, if you were to increase the base rate of the dividend, would that philosophically change how you guys look at the supplementals? Would you still be declaring those on a quarterly basis, or would you want some more cushion after you decide to take a leap and increase the base?

I think given kind of our risk-averse nature, our framework would be as follows, which is we would increase the dividend and where we think we can earn it, in a variety of cases, at 2 to 3 standard deviation of confidence, and therefore, given that, there's most definitely going to be -- continue to be supplementals, and so we would keep the formula in place to optimize return of cash to our shareholders. So I don't think you will see us get out way over our skis. I think we like our framework because it makes sure that we protect the dividend and protect NAV at the same time. So I don't think you'll see us getting out over our skis in increasing the dividend. But, look, the last -- I guess we've paid in the last 12 months $0.22 in supplemental dividends. That means we've over-earned it by $0.44. And so we'll keep that framework, because I think it allows us to make sure we -- people view that dividend as rock-solid and hopefully lowers our cost of equity. Ian, anything to add on that?

I think that's right. You did a good job.

And just on the Sears Chapter 11, I'm just wondering, A), if you guys are going to potentially maybe upsize this after this has been rolled up into a DIP loan, if there's potential to upsize, and what the prepayment fee is likely to be on that when it repays in the first half of '19.

No, I think it's outside of prepayment. I think that the loan today trades at 100-spot 101. It trades there because you have the ability to put in additional dollars, and if you owned the term loan, you were able to -- or owned a revolving commitment, you were able to put more dollars into DIP, which has decent terms. I don't expect us to upsize. We would love to upsize outside of our pro rata. I don't expect us to do so. As currently contemplated, you only get to roll up your pre-petition if you participate in the upsize, so I doubt anybody would leave their pre-petition behind, and so I doubt there will be an opportunity to upsize outside our pro rata, which is relatively -- I think it's like $5 million or something.

And a last one for me. I know you guys have opportunistically and successfully been investing in the E&P space. I'm just wondering how the kind of pipeline for opportunities looks there. Oil has been relatively stable to up a bit. I'm just curious kind of how you're looking at the opportunity set going forward.

So, look, I think we will -- I would suspect that it's not -- again, 0 is kind of an absolute number. We basically have 0, outside of -- I guess we have 1.3% of fair market value of our book in energy. I would expect us to be opportunistic and continue to increase there or do things on an opportunistic basis, and the pipeline -- the platform has a dedicated team in Houston, which is A-plus team and I think will continue to find attractive things.

(Operator Instructions) And our next question comes from Fin O'Shea of Wells Fargo Securities.

Just a small one on Caris Life Sciences. I'm seeing this is a pretty small hold in delayed draw as well. Is this an allocation or participation from another vertical, or is this a -- sorry, go ahead.

This is a good question. So, look, we -- TSL, along with affiliated funds, closed $150 million financing for Caris, which included a $50 million term loan, $50 million delayed draw term loan and $50 million of unsecured convertible notes. We acted as agent. Given the exemptive relief order, we get our first bite. Caris is a little bit further out on the risk curve, which drove the sizing. There are warrants related to the term loan in DDTL, and the unsecured notes are convertible, and so we -- the use of proceeds were to expand its sales force, expand laboratory capacity and to advance R&D. It's a privately-held sequencing diagnostics business. We think they are well-positioned, but it's clearly further out on the risk curve, which drove our sizing of the position. We think that the company has -- and so it was much more kind of biotech-y versus our typical biopharma, which has in place royalties. And so, again, the exemptive relief allows TSLX to size its position what it wants first. The sizing of that position was really kind of the risk -- kind of where it stood on the risk curve, and it didn't look as asymmetric in both the right tail and the left tail that our typical credit investments do, which we have really no left tail -- which we'd like to think we have limited left tail risk.

And then just bringing that into the context of gross originations versus commitments this quarter, I know you talked a bit about leverage, but I would have expected your commitments or fundings to be a little higher as a percent given they were low this quarter. Is that mostly due to Caris?

That's Caris, yes. So out of the $317 million, $150 million was Caris.

So if it was a more suitable deal for TSLX, you would have had a higher funding for it.

Yes. Exactly.

Thank you, and that concludes our question-and-answer session. I'd like to turn the conference back over to Josh Easterly for closing remarks.

Great. So, thank you. A lot of good questions. We look forward to -- I hope everybody has a good holiday season and a good New Year. We look forward -- we're always available, both myself, Mike Fishman and Bo and Ian and Lucy, and we hope people have a great holiday season and a great New Year, and we'll talk to people next quarter, if not sooner.

Thanks, everyone.

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.