Sixth Street Specialty Lending Inc (TSLX) 2018 Q4 法說會逐字稿

Good morning, and welcome to TPG Specialty Lending, Inc. fourth quarter and full year ended December 31, 2018 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 fourth quarter and full year ended December 31, 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-K 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 fourth quarter and full year ended December 31, 2018.

As a reminder, this call is being recorded for replay purposes.

I would now like to 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. Let me start by reviewing our full year and fourth quarter 2018 highlights. And then I will hand it off to my partner and our President, Bo Stanley, to discuss our originations and portfolio metrics. Our CFO, Ian Simmonds, will review our financial results in more detail. And I will conclude with final thoughts before opening the call to Q&A.

After market closed yesterday, we reported our strongest quarterly net investment income per share since inception of $0.67 resulting in a full year net investment income per share of $2.25. Our fourth quarter and full year net income per share were $0.22 and $1.86 respectively. The difference between this quarter's net investment income and net income was primarily driven by $0.23 per share of unrealized losses from the impact of widening credit spreads on the valuation of our portfolio and $0.29 per share of reversal of net unrealized gains from full investment realizations. This was partially offset by unrealized mark-to-market gains of $0.10 per share related to our interest rate swaps resulting from the flattening of the forward LIBOR curve during the quarter.

Our return on equity based on net investment income for the quarter and full year were 16.4% and 14.0% respectively. And our return on equity based on net income for the quarter and full year were 5.3% and 11.6% respectively. For the quarter, if we are able to isolate the unrealized losses related to credit spread movement of $0.23 per share and unrealized gains related to our interest rate swaps of $0.10 per share, our annualized Q4 ROE on net income calculates to 8.5%. Similarly, for the full year, if we are able to isolate the impact of Q4 spread movement and the full year cumulative unrealized losses related to our interest rate swaps of $0.03 per share, our 2018 ROE on net income calculates to 13.2%. As it stands today, based on the year-to-date tightening of the credit spreads, we would expect to see a partial reversal of fourth quarter's unrealized losses related credit spread widening in Q1.

Note, our net income for this quarter was burdened by $0.29 per share of reversal of unrealized gains from the prior quarter, predominantly driven by our Northern Oil investment. This was because our prior quarter's net income included unrealized gains from investments where we had visibility on collecting contractual prepayment fees, consistent with fair value accounting principles. Upon the prepayment of those investments this quarter, we recognized their prepayment fees in investment income and unwound their respective unrealized gains. Said another way, the prepayment fees from Northern Oil were pulled forward into Q3's net income, and as the loan repaid this quarter, those fees ran through net investment income and burdened this quarter's net income through the unwinding of those unrealized gains.

Moving back to the results, reported net asset value per share at year-end was $16.25 compared to $16.42 at Q3 and $16.06 for the year-end 2017, the latter two metrics each after giving the effect of supplemental dividends declared for those periods. Factors contributing to net asset value movement during Q4 include the over-earning of our base dividend through NII, which was offset by the reversal of net unrealized gains from investment realizations during the quarter as discussed. In addition, there was a negative impact of credit spreads widening on the valuation of our portfolio, which was partially offset by mark-to-market gains on our interest rate swaps.

Yesterday our board announced the first quarter 2019 base dividend of $0.39 per share to shareholder of record as of March 15, payable on April 15. Our board also declared a Q4 supplemental dividend of $0.12 per share to shareholders of record as of February 28, payable on March 29. As part of our variable supplemental dividend formula, the amount declared this quarter was the lower of 50% of this quarter's net investment income in excess of the quarterly base dividend, and an amount that resulted in no more than $0.15 per share decline in net asset value over the current and preceding quarter. Ian will discuss the calculation mechanics in more detail later.

When we introduced our variable supplemental dividend framework in Q1 2017, our objective was to maximize shareholder distributions matching the earnings power of our business while preserving the stability of net asset value. We are happy with how our framework has worked to-date. Through earnings generated across full-year 2018, we declared a total of $0.31 per share in supplemental dividends while increasing net asset value per share, pro forma for the impact of supplemental dividends, from $16.06 to $16.13 per share. This represents a 5% increase in dividends declared year-over-year and a 20% increase in total dividends over the full annual base dividend of $1.56. Our dividend framework has allowed us to drive consecutive annual increases in our book dividend yield which was 10.3% in 2016 prior to introduction of the supplemental dividend framework, 11.2% in 2017 and 11.6% in 2018, all while growing net asset value per share. This is made possible by our focus on generating consistently strong ROEs.

Before discussing our results in detail, I'd like to make a comment on the market conditions. As we approached the end of Q4, there was considerable widening of risk premiums across asset classes due to concerns about global growth, U.S. China trade uncertainty, and Fed policy. From Q3 to Q4, LCD first and second lien spreads widened by 112 basis points and 81 basis points, respectively. In December, a record $11.6 billion of loan retail outflows, representing more than 9% of retail AUM, led to a 3 point-plus declines in loan prices, resulting in the lowest price levels since early 2016. Note that the wider risk premiums were also reflected in trading prices across the BDC sector.

While most of our portfolios is comprised of illiquid middle market loans, we believe changes in liquid credit risk premiums reflect the collective views of the market, including those about the probability of default, loss given default, and the required compensation to take such risk. As a matter of policy, we reflect movements in liquid credit risk premiums, in combination with our assumptions on the weighted average life of our loan investments, in the fair value of the portfolio every quarter. Not only is this consistent with fair value accounting principles, it also provides us with valuable risk management insights and early warnings into our portfolio and investment opportunities.

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

Thanks Josh. 2018 was our second highest year of originations since inception at $2.2 billion, primarily due to the larger financings completed during the first half of the year. During Q4, we generated gross originations of $373 million across 4 new investments and upsizes to 6 existing portfolio companies. $204 million of the gross originations were allocated to affiliated or third party funds and $22 million consisted of unfunded commitments. Over 60% of this quarter's gross originations were in existing borrowers that we know well and over 85% were in agented transactions, which allows us to have greater control over the loan structuring and monitoring process.

As for repayment activity, this was our highest quarterly level of repayment since inception at $383 million from 8 full realizations, 2 partial pay downs and 1 partial sell down. This was driven by a combination of M&A activity and opportunistic refinancings, resulting in strong activity related fees contributing to this quarter's top line results.

Underlying middle market lending environment throughout 2018 continue to be highly competitive given the ongoing strength of the private debt fundraising, which at year-end reached a record level of $280 billion in dry powder according to Preqin. Given the supply-demand imbalance, there have been instances of what we believe to be irrational behavior where market participants were willing to lend at prices inconsistent with underlying deal dynamics, the need for an illiquidity premium compared to the broadly syndicated loan market, and associated spreads required for today's late cycle environment.

One such example during the quarter, we were refinanced out of a debt investment at 103 call protection by a co-lender who, despite having the benefit of the call protection, was willing to re-price the facility at a spread that was 225 basis points tighter than the existing levels with greater transaction leverage. For us, we're not motivated by the desire to gather assets or to gain market share, but rather by the desire to generate the best risk adjusted return for our shareholders.

Circling back to our portfolio, total repayment levels for 2018 were elevated at $790 million, which against total fundings of $817 million, resulted in a net portfolio growth of $27 million for 2018. Given the highly competitive environment, we believe our ability to grow the portfolio while improving the credit quality and metrics of our portfolio speaks to the depth and breadth of our platform's origination and investment capabilities.

Year-over-year, we decreased our junior capital exposure and improved our average interest coverage and net leverage profiles of our core portfolio companies. Meanwhile, our exposure to the non-energy cyclical industries remain low at 4% of the portfolio at fair value, consistent with the prior year. And our energy exposure decreased from 5.5% to 2.3% of the portfolio. We continue to have no investments on non-accrual status at year-end, and the overall performance of our portfolio improved year-over-year from 1.22 to 1.14 based on our assessment scale of 1 to 5 with 1 being the highest.

At year-end, our portfolio was well diversified across 46 portfolio companies and 17 industries. Our largest industry exposure continues to be the Business Services at 19.3% of the portfolio of our fair value, followed by Financial Services at 19.2% of the portfolio at fair value. Note that our Business Services portfolio companies consist primarily of businesses with diversified revenue characteristics, and the vast majority of our Financial Services portfolio companies are B2B integrated software payments businesses that are diversified by sectors with limited financial leverage and underlying bank regulatory risk.

Given our commitment to our direct origination strategy, at year-end, 98% of our portfolio by fair value was sourced through non-intermediated channels. This supported our ability to structure effective voting control on 84% of our debt investments and average 2.1 financial covenants per debt investment consistent with historical levels. The fair value of our portfolio as a percentage of call protection remain stable at 95.9%. This metric means that we have over 4 points of additional economic should our portfolio get repaid in the near term. Our focus on structuring call protection in our debt investments has been one of the key drivers of our outperformance versus our full year guidance during the course of 2018.

As for portfolio yields, at year-end the weighted average total yield on debt and income producing security at amortized cost was 11.7% compared to 11.3% in the prior quarter. This increase was primarily due to the increase in effective LIBOR across our debt investments and to a lesser extent, the yields impact of new versus exited investments, which were 12.2% and 11.2% respectively.

Now, let me highlight some of themes in our portfolio activity during 2018. Nearly 65% of our gross origination this year were sponsored transactions. These are primarily investments in business models characterized by high revenue visibility, strong cash flow margins and high returns on invested capital. Here, our philosophy is to invest when we can differentiate our capital, whether it's through our platform's deep sector knowledge and relationships, and/or ability to move quickly and provide certainty of execution.

The remaining 35% of our 2018 originations were what we call opportunistic capital deployment in areas where our platform's ability to underwrite and navigate complexity and process risk allow us to create excess returns across our portfolio. Examples since inception include our investments in upstream E&P, retail ABL, and secondary market purchases during periods of market volatility. These also include opportunities arising from the challenging regulatory environments for banks, such as our larger financings in iHeart and Ferrellgas. Since inception through year-end 2018, the gross unlevered IRR on our fully realized investments that we designate as opportunistic in nature was 28%, which compares to a gross unlevered IRR of 14% across the remainder of our fully realized investments over this period of time.

Depending on the market environment, the mix between our sponsor-oriented versus opportunistic originations activity may change based on where we believe we can find the best risk adjusted returns for our shareholders. We're optimistic about our near term pipeline and we continue to develop themes and finding situations that reward our ability to underwrite and manage complexity, such as retail ABL and upstream E&P.

As you know, we don't control the timing of our portfolio repayments, which seem to come in waves in Q4. But to provide a sense of our post year-end activity, our net fundings year-to-date stand at approximately $100 million.

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

Thank you, Bo. We ended the fourth quarter and fiscal year 2018 with total investment of $1.71 billion, total debt outstanding of $624 million and net assets of $1.06 billion or $16.25 per share, which is prior to the impact of the $0.12 per share supplemental dividend that will be paid during Q1.

Josh referenced earlier the calculation mechanics on this quarter's supplemental dividend. And given this is the first time that the NAV constraint has come into play, we thought it helpful to walk through the calculation. Based on NII per share of $0.67, 50% of the over-earning against our base dividend per share of $0.39 implies a supplemental dividend per share of $0.14. That's the first part of the calculation.

The second element in the calculation is specifically designed to ensure we take into account the movement in our NAV over a 6 month period, given it reflects the impact on NAV from unrealized and realized gains and losses, as well as the impact of supplemental dividends. For the purposes of calculating the NAV constraint, we compare the pro forma NAV per share at the end of Q2 of $16.28 to $16.11, which is this quarter's reported NAV per share of $16.25 less the calculated supplemental dividend of $0.14. This represents an NAV decline of $0.17 over that period, exceeding the prescribed limit of $0.15. Consequently, the supplemental dividend amount this quarter is reduced to $0.12 per share to ensure the NAV decline is constrained to no more than $0.15. As this quarter illustrates, during periods of market volatility that result in downward pressure on portfolio valuations and unrealized losses, our supplemental dividend framework helps stabilize NAV and retains additional capital for us to utilize in more attractive reinvestment environments.

Back to this quarter's results. Our average debt-to-equity ratio during Q4 was 0.71x compared to 0.91x in the prior quarter and point 0.84x for the full year 2018. And our leverage at December 31 was 0.59x, given the high level of repayments we experienced during the quarter. At year-end we had significant liquidity with $752 million of undrawn revolver capacity. Given the quarter-to-date net funding that Bo discussed, our leverage has increased since year-end and returned to approximately 0.7x today. Again, as we experienced during Q4, the timing of repayments can be variable. However, we are encouraged by the depth of the pipeline today.

A brief comment on our liability structure, as we have developed this extensively over the past couple of years. Just last week we closed an upsizing and extension of our revolving credit facility, increasing commitments to $1.17 billion, increasing the accordion to allow for commitments of up to $1.5 billion, and extending the final maturity to February 2024. The remaining key terms including pricing remain unchanged.

In December this year, we have the maturity of our $115 million Convertible Notes. Given the significant available liquidity and low marginal cost of funding under our revolving credit facility, our base case is to refinance our 2019 notes using our revolver. However, should conditions in the debt capital markets become more favorable than they are today, we would look to issue new unsecured notes. We believe our investment grade ratings from four rating agencies, Moody's, S&P, Fitch and Kroll, provide us with a competitive advantage in accessing lower cost funding relative to the majority of the BDC sector. We are also mindful of maintaining an appropriate mix of secured versus unsecured debt to ensure funding diversity for our business from both a sourcing and a maturity perspective.

I'd like to take a moment to discuss our interest rate swaps and the downside protection feature of this risk management practice. As you may be aware, we implement fixed-to-floating interest rate swaps on our fixed rate liabilities to match the floating rate nature of our assets. In falling interest rate environment, which typically coincide with periods of weaker economic sentiment, 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 that we structured into our investments, thereby providing net interest margin expansion for our business under those conditions.

Moving on to our operating results detailed on Slide 11, total investment income for the fourth quarter was $74.7 million up $11.7 million from the previous quarter. Breaking down the components of income, "Interest and Dividend Income" was $52.1 million, down $4.6 million from the previous quarter driven by the decrease in the average size of our debt portfolio. "Other Fees" which consist of prepayment fees and accelerated amortization of upfront fees from unscheduled pay down were $21.2 million for the quarter compared to $5.2 million in the prior quarter. Circling back to what Josh discussed earlier, $15 million of this quarter's "Other Fees" were embedded in prior quarter's unrealized gains and unwound this quarter as we recognized fees upon investment realizations. "Other Income" was $1.5 million for the quarter compared to $1.2 million in the prior quarter.

Net expenses, excluding management and incentive fees, for the quarter were $13.2 million, down from $15.7 million in the prior quarter primarily due to lower interest expense and other operating expenses. Interest expense decreased by $1.5 million as a result of the decrease in the average debt outstanding during the quarter. Our weighted average interest rate on average debt outstanding increased from 4.3% to 4.5% quarter over quarter due to an increase in the effective LIBOR across our debt instruments and a shift to a higher unsecured funding mix. This shift being caused purely as a result of the payoffs we experienced on the asset side. As we re-lever, we would expect to see a benefit from a shift to our lower cost revolver funding.

On our previous calls, we announced our revised financial policy of 0.9x to 1.25x target debt-to-equity ratio in conjunction with our reduced asset coverage requirement, which was made effective in October through a special meeting of our shareholders.

Our balance sheet leverage during the quarter and the year-end were below our revised target range, which is consistent with our disciplined approach to capital deployment in today's late cycle and competitive environment. To the extent, certain aspects of the current competitive market dynamics persists, we believe it is prudent to continue to operate slightly below our new target leverage range to reserve capital to invest in higher ROE opportunities.

Before I pass it back to Josh, let me provide an update on the ROEs of our business. In 2018, we had the best of both worlds from an ROE perspective. We were able to operate with meaningful financial leverage through most of the year, while generating strong fee income from repayment activity, the bulk of which occurred during the fourth quarter.

As we look ahead to full year 2019, based on our expectations over the intermediate term, the net asset level yields, cost of funds and financial leverage of 0.7x to 0.75x, that may be slightly below our new target range, we continue to expect to target a return on equity of 11% to 11.5%. Based on our pro forma year-end book value per share of $16.13, this corresponds to a range of $1.77 to $1.85 full year 2019 net investment income per share. Should the market opportunity set allow us to operate at the higher end of our new target leverage range, we would expect to drive up to approximately 250 basis points of incremental ROEs for our shareholders.

As we've said before, if we believe there's a sustainable increase in the earnings power of the business by operating in our target leverage range for an extended period of time, then we would look to resize our base dividend in context of the underlying earnings power of the business to ensure we're optimizing cash distributions and satisfying RIC-related distribution requirements. At year-end, we had $1.22 per share of spillover income. We will continue to monitor this figure closely as part of our ongoing review of our distribution strategy.

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

Thank you, Ian. 2018 has been a productive year for our business. Despite the challenging competitive environment, we generated net portfolio growth while maintaining our high degree of investment discipline and productivity, as reflected in our portfolio metric and yields.

On the balance sheet side, in March, we completed a small secondary equity issuance that was immediately accretive from an earnings and book value basis, which drove a return on net asset value of 12.1% versus the return on equity based on net income of 11.6% for the full year. We also completed two opportunistic debt capital market transactions, in January with our inaugural unsecured notes issuance, and in June with the reopening of our 2022 Convertible Notes. Both of these transactions had minimal drag on ROEs and enhanced the funding diversity of our business. Finally, as mentioned, we were successful in obtaining our stakeholders' support for access to increased financial flexibility, which not only provides regulatory relief for our business, but also the potential to drive incremental ROE for our shareholders. As part of this process, we were one of a few BDCs to maintain investment grade ratings profile from both S&P and Fitch. We also added investment grade ratings from Moody's and Kroll during the year. As a result of the groundwork we did in 2018, we entered 2019 well-positioned to serve our clients and create high risk-adjusted returns for our shareholders.

Before taking questions, I'd like to touch upon a regulatory topic affecting BDC investors. As most of you are familiar, in December, the SEC issued a release proposing a new 3% Rule that would allow 40 Act companies down more than 3% of the outstanding shares of other investment company. However, this new proposal, as drafted, requires that funds who own more than 3% of another fund vote those shares in a manner consistent with the broader voting outcome, or receive voting instructions from their own shareholders and vote proxies accordingly. While this new rule, like the exemption of BDCs from Acquired Fund Fees and Expenses, could potentially improve institutional ownership, liquidity and valuations in the BDC sector, we believe the proposed voting restrictions continue to handicap the ability of investors to drive positive change through governance, to the detriment of all shareholders across the sector.

Since our IPO, the BDC sector has generated an average annualized return on equity that's well below its cost of capital and traded at a meaningful discount to book value. During this period there hasn't been any meaningful consolidation in the BDC space given the ownership and voting impediments of the 3% Rule. We applaud the SEC's focus on this area, but believe the new 3% Rule, as currently proposed, continues to mute effective governance in our sector. We will be submitting our comments to the SEC regarding this topic, and we'll post our letter to our website. We encourage our listeners to visit the SEC website to also comment on this proposed Fund of Fund Arrangements Rule.

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

Thank you, sir. (Operator Instructions).

And our first question will come from Rick Shane with JP Morgan. Your line is now open.

Two things. First of all, on Slide 16, you show both the ending debt to equity and average debt to equity. And I understand in the quarter, like the fourth quarter, where you had net repayments, why the average would be above the ending? But it's consistently above the ending and I'm curious what drives that?

So I can answer as it relates to Q4 and then we'll come back to on historically. So Q4 we had a decent amount of prepayments. Sorry, Q4 we had a decent amount of prepayments at the beginning of the quarter and some at the end, so it's just a matter of where it falls quite frankly in the quarter. But we'll come back to what the exact data is. We calculate on average daily basis, right Ian?

Yes. So, I mean, technically we don't calculate equity on a daily basis, but we do have the cash balances and withdrawn amount on the revolver so that that's a truer number. But if you were just to look at our equity balance between 9/30 and 12/31, you'll see that it don't really change that much.

And then second question, you guys in your fair value approach incorporate liquid markets in a fulsome way. I'm curious, can you help us understand how to think about those input? How granular is the approach? Are you looking at those inputs, those market inputs based on sector and type or are you just using an overall spread and what should we use as a benchmark and what should we think about as a beta?

Yes, so great question. So very good question. So first of all, let me take a step back and talk about philosophy. The philosophy is that the broadly syndicated market offer the collective, as we discussed, the collective insights of a range of investors on the credit risk premiums required for the possibility of default and probability of default and the loss given default anytime. And this idea that the broadly -- that the middle market is insulated from risk premium because it doesn't trade is a little silly to us. It's silly in a couple of different ways. One is it's silly in the sense that given the fee structure embedded in BDCs and the fee structure embedded in private funds, you have to earn an illiquidity premium to provide value to your underlying clients, and if you are in that liquidity premium, think of it as stable over time, but the underlying reference isn't and so you got to be thinking about for you to create value for your underlying shareholders or LPs and private funds, you got to be thinking about the value proposition as it relates to, given where you are in the cost curve, as it relates to the underlying reference credit risk premium. The second piece is that you got to think about, if you don't mark your book, you are missing the market signals both as it relates to risk or opportunities. And so it's not only a kind of a GAAP valuation policy for us, but for us it's really a risk management policy. Now specific to your question, it's pretty granular. So we look at underlying based on sectors and based on broadly syndicated comp credits. Those sectors and where we are investing in the capital structure, we look at those movements in credit spreads and then roll those movements in credit spreads across the weighted average life of an individual investment. And so the way I would think about it is the beta of the broadly syndicated market is probably 50%, somewhere between 30% and 50%, which is a function of really that we have a shorter weighted average life of our portfolio given the capital structures, maturity, et cetera. And so obviously if you have a company that has maturity in a year, it's going to have a lot less dollar price movement than if you have a company that has a maturity of 8 years, which we have none. But when you look at the beta or the marks, that the spreads are completely incorporated on the bottoms up basis and if there is a difference as it relates to the weighted average life of an individual investment. And one other comment just on the spread. What it really have the impact is it really, if you think spreads normalize, it really has the impact of moving earnings on a net income basis from 2018 into 2019. You saw this with us, if you look back, you saw this with us in 2015, fourth quarter of 2015 spreads blew out and they recovered starting in Q2'16 and through the rest of the year and so net income in 2016 significantly outpaced net investment income. And so for example I think ROEs in 2016 on net investment income was like 12.1%, ROEs on net income was 15.4% that year, you had $2.34 per share on net income and a $1.82 on net investment income and that was basically a shift between '15 and '16. And so the credit quality of the book continues to remain very, very strong. Again we take both the risk management aspect and the fair value aspect of marking our book seriously.

Thank you. And our next question will come from Leslie Vandegrift with Raymond James. Your line is now open.

Just a quick follow up to that on the spreads and the impact to the portfolio. Just roughly how much of that do you think that impacted the fair value mark has reversed so far in first quarter '19?

I gave you our estimates. We think it's probably 40% to 50%. So Q4 firstly in spreads were LIBOR 449, today they are LIBOR 400. Secondly spreads were 928 and 916 just probably as of a couple of days ago, that would imply about probably 40% to 60%. So think of it as $0.10 to $0.12 per share if we ended the quarter today. So who knows what the market holds, but you would expect if the quarter ended today that you would have a decent amount of that roll back through and reverse.

And on one of the new investments in the portfolio for the quarter, PrimeRevenue. It has got a pretty low cash coupon, it looks like L+350 and but then it has also got 5.5% PIK. Can you just give some color on that investment?

Sure, and I'll let Bo talk about it. PrimeRevenue is a software business in the Financial Services, that is a -- we think is a really super interesting business. It's a supply chain finance company, it offers a Saas-based product which connects buyers to suppliers and funders and kind of the reverse factor in the marketplace. The return on invested capital in that business is very, very high to acquire new customers and so we've allowed them because of its credit enhancing and the returns are so high, to continue to take excess cash flow and go and acquire new customers. If you run that business like on a steady state earnings basis where they are not growing and given there is a sticky underlying customer base, I think it was like 2.5x or 3x levered, if my memory serves me, and the interest coverage was significantly high. So it's a product is a really, really interesting business that has high return on invested capital, sticky embedded customers that you could, the company could run at significantly high free cash flow margins, if they weren't growing in customers and that return on those new customers were very high. Bo, anything to add there?

No, I think that's exactly right. I'm just reiterating, this is running on a steady state basis, we believe it would be between 2x and 3x levered. But because of the strong return on invested capital, we allow them to reinvest those dollars back into the business and drive further margin of safety.

And two of the exits for the quarter happened to fall in what you called Marketing or Marketing Services in the portfolio. Is there any connection there or is that just happenstance that it occurred in the same quarter?

Happenstance.

Happenstance.

And then finally, you had one new energy investment in the quarter, MD America.

Yes,

Was that opportunistic given the way that energy, oil has been moving in the last 4 months I guess and if so what's the kind of thought on that going forward?

Yes, so opportunistic, look, on upstream E&P we've historically done very well, ex-Mississippi Resources to be open and honest as we always are. But we have historically a lot of net P&L, even incorporating unrealized losses, realized losses in the sector. So look, we like to lend in today's commodity price environment, not in a commodity price environment that's 30% to 40% higher. And so you'd expect us to continue to do more opportunistic stuff in energy given today's commodity price and quite frankly where there's assets that are producing in low cost basins with hedged collateral cash flow.

And then just finally, kind of on that point, were there any other opportunistic investments that were simply because of the market volatility either at the end of last year or even so far in the first quarter?

Look, first quarter, our pipeline is really strong. I think Bo talked to you or Bo, a combination of Bo and Ian has talked about it. We already have a $100 million of net funding this quarter. That pipeline on the opportunistic side is actually very, very strong and so that volatility, it wasn't like Q4 quite frankly, it was December, didn't really last long, things snapped back, but we continue to -- we feel really good about the pipeline and continue to drive value both on -- as it relates to both our sponsored business and our opportunistic business. But the pipeline feels pretty good both on the retail side, specifically on the retail side.

Yes, that's right, Josh. I think we've seen market activity picking up in the retail ABL and some of the thematic origination sources on the opportunistic side. I think in addition to that after a relatively slow December because of the market volatility and M&A, we've seen a pickup in the pipeline. So we're very encouraged by both the breadth and depth and in the stage where our pipeline is at today. It's a very competitive environment. We're always going to be very disciplined with our shareholders' capital, but we feel very good about the depth of the pipeline.

Thank you. And our next question will come from Terry Ma with Barclays. Your line is now open.

So I'm just curious. To the extent the competitive environment doesn't change or gets more competitive, how do you guys think about growing and investing or to maintain the portfolio and sustain ROEs going forward? And just talk about some of the things you're looking at?

Sure. So first I think the earnings estimates or thoughts that are provided on return on equity was really -- I would say assuming the competitive environment as of today, I think it had the assumption of us running only at 0.7x leverage, which quite frankly is where we are today. And so the idea that we can earn 11% and 11.5% ROEs while improving the quality of our book and not forcing us to grow, we think that's a very good value proposition for shareholders in today's late cycle market. And if there are opportunities to grow that are accretive to ROE, we feel that will obviously drive incremental returns to our shareholders. So at the top end of our target range, that's another 250 basis points of ROE expansion above that 11% and 11.5%. So you have known us a long time, we like to under-promise and hopefully over-deliver. And quite frankly, the 11% and 11.5% ROE is basically on a no growth case. And would be running the business and we think we have obviously the quality and the platform and the underlying strategies to do that in today's competitive environment and then provide upside for shareholders in an environment where there is more volatility for us to continue to drive -- for us to lever the business and drive incremental ROEs.

And then you mentioned earlier that if spreads kind of normalize, it'd be accretive on a net income basis. Can you just give me an idea of what the magnitude is when you refer to normalization?

Well, I think what we said, well, I don't know what normal spreads are to be honest with you. So spreads should be a function of people's expectations of defaults and people's expectations of -- and I'm not sure what the rest of the world thinks about this, this is how it should work. Spreads are compensation for people take credit risk, spread should be a function of the expectations for default and the losses given defaults. And so as people's perception of defaults go up and people's perception of the -- that recoveries go down and so there is credit losses, that spread should go up to compensate, lenders or investors. So the idea of normalized spreads is really a function of the inherent risk for taking credit risk. What we did say was that spreads have snapped back between the end of Q4 and as we sit today. And so given that's a function of a more accommodate Fed and that obviously rising rates hurts investments, consumers, increases the required return on capital investment, and has an impact of slowing the economy and so an accommodative Fed has pushed, has the perception of pushing out any type of economic recession or a credit cycle. And so spreads have come back in, given the accommodative Fed and if you would run those spreads through our portfolio today, you would have $0.10 to $0.12 of the reversal of that $0.23 in Q4 that would run through NI in Q1. But the idea of normalized spreads is really a function of what the idea of defaults and losses are.

Thank you. And our next question will come from the line of Christopher Testa with National Securities. Your line is now open.

Josh, I appreciate your commentary and your actions on actually valuing the portfolio. I know you had answered risk question in relation to this before. But just expanding on that a little bit, in mid '15 into early '16 when spreads widened, BDCs were not citing insulation generally and a lot of your peers were still accordingly marking their books, but thus far as of the ones that reported, it has basically just been you guys at this point. I'm just wondering if there's any inkling of a merit to them in citing that or whether this is just kind of likely a shift in what they're looking at?

Yes, my memory to the little bit, I think there is a lot of spread across, look we used to do this, which was we used to keep track of club names where we had in our portfolio where we shared investors across the BDC sector. And what you will historically have seen was that the sector keeping every single investment at the prior quarter's mark though, our mark would go from '99 to '98 to '97 to par to '99, and the rest of the sector would leave it at par and so we would actively mark our book based on credit spreads and people would often say to us why do you not trade below book value, we would say, well because we marked our book and either you're going to mark your book or the market's going to mark it for you. And so my memory on '15 or '16 is a little different. There has been a ton of competition for middle market loans. What I would take pause at is that middle market loans by their nature haven't been insulated to increases in leverage and haven't been insulated from loosening of credit documents. They are typically smaller companies who have probably slightly more vulnerable market position. And so I would argue that even if there has been more competition and because of the technical side of capital raising and middle market loans, people are going to long-term provide value to both shareholders or their LPs, they better look at getting a liquidity premium, both to compensate for additional credit risk because they are middle market. Second, to provide for that you having less option value to reinvest your capital because there is not a buyer for that loan. And third, to make up for where you sit in the cost curve because people can buy a portfolio of broadly syndicated loans way cheaper than they can through BDC. So if people are trying to get access to credit risk premiums because they think credit risk premiums are valuable or are (inaudible), they better understand where they sit in the cost curve as well.

And sticking with the theme of volatility in the liquid credit markets, is it safe to say that if this were sustained for a longer period of time that potentially you could see more sponsor backed companies valuing certainty of execution more than they do currently kind of in a more complacent environment or do you think that's sort of the same with you as the sponsors that you tend to come across?

No, I think quite frankly when you've seen market volatility, we've moved up company size, people start valuing certainty more and quite frankly we often have historically, although this time snapback very quickly, in longer periods of volatility, we've created a ton of value by buying names at secondary market at discount. And so by the way, that is the other reason why people should market their book because if they don't mark their book, they miss the opportunity to create on a relative value basis a whole bunch of value for their shareholders. And so if volatility is the sustained, the playbook is: larger companies, providing certainty in paper, certainty, and finding names at discounts that we know that have big margins of safety that have, were previously middle market borrowers, now are broadly syndicated borrowers where we can buy at discounts that ultimately pull to par. And so of a lot of value creation between in 2015 and 2016 our business were those two things.

And I know you guys have said that your plans for the 2019 Convertibles coming due is to use the revolver which is obvious. My question is when you look at what would be a more favorable case, obvious you can go one of two ways, right, you could either have much wider spreads where you're going to bite the bullet on a higher borrowing cost and just issue the notes in that environment or spreads come in and you have got kind of a crappy reinvestment environment operate to issue those notes cheaper. Is there one that's more favorable than the other or more liquidity than the other that you are looking at for (inaudible)?

Yes, I think, so I will let Ian hop in, but let me give you the overlay which is the business is really, really setup to provide optionality, which is today, liquidity, Ian is probably.

Well, we have $750 million at the end of the year, but then we upsized our revolver by $230 million. So it's a significant amount of liquid even accounting for the additional funding.

Additional funding, right, so there is probably $800 million plus of liquidity today, which really gives us the optionality to create value. Our marginal cost of funding on our revolver, when you think about it, the spread of 187.5, our unused line fee is 37.5 basis points. So the marginal cost is really LIBOR 150. And so the base case, if you have a more favorable environment, it's clearly given our liquidity profile and how we position the business is that loan out spreads and we just extend our revolver and funding in that environment where there's spreads blown out and funding the portfolio at LIBOR 150 given that we have a lot of optionality on the reinvestment side given the duration and costs of our revolver.

And if you guys do indeed go the route of another unsecured note, is it safe to say that you would swap out the fixed rate portion of it?

Yes, look, here Ian talked about this. Here is our philosophy. We're down side people, it comes across to our business, it show I think in the performance of the business, the ROEs and the credit of the business and so when we are making that call, we basically have come to the belief that we have a core competency originating and managing credit risk in corporate loans. We don't have a core competency on competing against central government as it relates to playing the rate game, and so we're a spread business and in an environment where if you are leaving it fixed, you're making an implicit bet that, you might not know when that rate is going to rise and we're not making that bet. So the trade we are making is we are giving up a little bit of upside of earnings expansion in an environment where rates continue to rise, but quite frankly what we are gaining in the down side because we have floors on our assets that we have net interest margin expansion at the time you most need it, which is in a downside where you have credit, where you have credit issues. And so some of that net interest margin expansion really offset, has the potential to offset your credit issues. And if you did not do that, where you ended up with is that you would have a fixed rate -- you would have a floating rate, you would have a fixed rate cost structure and then on the down side, you would have net interest margin get tighter at the time that you have credit issues. That seems like a still a risk reward proposition for shareholders. Even though that if you are optimistic, the world keep going up into the right and rates keeps going up in the right. We rather give up that corner case of upside that really create value in the downside for our shareholders.

Thank you. And our next question will come from the line of Michael Ramirez with SunTrust. Your line is now open.

It seems Financial Services has increased as the part of your overall portfolio. Could you please help us understand the greater opportunity you may see within this industry?

Sure. Let me turn it to Bo. Financial Services, I think as a little bit of a tough way to frame it. What they really are is business services or integrated software payment businesses that would generally fit inside the financial services. So Bo can talk about one maybe PaySimple and I'll talk about GTreasury. GTreasury is really a treasury management software business that is obviously part of the financial service of the ecosystem. And so don't think of these as balance sheet credit investments. These are companies that are not taking credit risk, that don't have balance sheet, but that are part a broader financial services ecosystem. Bo, you want to talk about PaySimple?

Sure, as Josh mentioned, this part of a broader theme that we've had over the last five years between the intersection of technology and software businesses in payments, where we saw the adoption cycle of B2B payments lagging well behind the B2C consumer. It's an area that we focused on investing, PaySimple is a great example of that, which is the business that provides software solutions to small and medium sized businesses that help run their businesses on a day-to-day, it's a very deeply embedded software. They also overlay payments engine that allow their service providers to take payment upon delivery of services, which creates a very sticky and growing recurring revenue stream characterized by high free cash flow and high returns on invested capital. So this is a theme that will continue to be active and we're in the early stages of this adoption cycle.

Like I said, helps with your extensible portfolio given this current environment. And we may have sort of touched on this a little bit in your comments and some of your answers. But given you remain prudent to operate below your targeted leverage range, could you please lay out some parameters or conditions both internal and external you would consider operating at both the lower and the top end of new target range in 2019?

Sure. It might be helpful to talk about philosophically. Look, so where if you think you're late cycle, the way you express risk or the way we express risk is: what sectors we invest in, where we invest in the capital structure, and what our financial policy is. And so that a -- you've seen us move up the capital structure, you've seen us take less risk as it relates to cyclical businesses and you've seen us not lean in to the new financial policy to grow assets, and that's a function of our expression of risk and where we think we are in the cycle. And so in an environment where risk premiums are more compelling, so spreads are wider, where there is fear, you will see us change on all three of those fronts. So you will see, for example, in 2011 and 2012 I think our biggest portfolio positions if my memory serves me was Mannington Mills, which is building products business, and Federal Signal, which was selling capital equipment into municipalities. And so you will see us move more into cyclicals, you will see us move down the capital structure and you will see us lean into our financial policy a little bit. So it is -- for us to be lean into our financial policy, you'd have to see a better risk reward environment where quite frankly the thing I hope the sector realizes is the gift of the -- the sector has a variable, a very valuable place in the -- for shareholders as long as they understand that they don't lean into their financial policy and take their leverage up to the maximum and keep that reinvestment option to create value in a wider risk premium environment. And so with prior to global financial crisis and under the old regulatory regime, right, the sector didn't have the option to reinvest. And so what ended up happening if you're running 0.85x leverage and you had -- were worried about your leverage as you're going through the down cycle, you had no ability to create value in a higher risk reward premium. The one exception would Ares. Ares did a fantastic job through M&A, through Allied specifically where they were able to effectively buy assets at low prices and low valuations at that time of the cycle. If you're able to keep that reinvestment option open, that sector's earnings power is the ability on net asset value will be much greater in the next cycle and quite frankly that was a gift from the regulators in the SEC.

Thank you. And our next question will come from the line of Derek Hewett with Bank of America Merrill Lynch. Your line is now open.

Could you talk about the growth in the portfolio yield on a cost basis? I know it's still early in BDC earning season, but it looks like the pure average is down about 10 basis points versus the 40 basis point increase that you guys witnessed this quarter. Was that a function of just the prepayments? And then should we expect the yield to normalize a little bit lower going forward?

Yes. So some of those assumption of LIBOR, right. So thank God, we had asset sensitivity. We own floating rate assets. LIBOR, effective LIBOR on our portfolio contributed about 30 basis points. And on new versus exited investments, that was about 10 basis points.

Thank you. And our next question will come from the line of Finian O'Shea with Wells Fargo Securities. Your line is now open.

Just first, you've touched on this and a lot of vantage points, but specifically this quarter what prevented you, according to your views of the technical softness in liquid markets and the private credit staying the same, what prevented you from leaning into loan or bond markets?

You mean what prevented us from going and buying a ton of broadly syndicated loans or bonds in those basically two weeks in December?

Yes.

I would say it was two weeks.

Sure. Okay, so the time period -- so if this lasted three or four months?

Yes, you saw what we did in '15 and '16. We built that portfolio I think in predominantly Q1'16, but like two weeks is not a lot of time to make educated calls on any of the credit names, which is how we operate our business. Well, we don't operate our businesses and say, God, there is a technical soft, that market seems cheap, let's go buy an index or a basket of bonds of broadly syndicated loans and with the hope that things are now back. What we say is, look, people are not appropriately pricing middle market loan, let's go find idiosyncratic credit names that we know very well that are mispriced because of that technical or because of that sell-off in the broadly syndicated market where we have a differentiated view either because we know the sector, we know the industry, we've financed the company previously, where we can create value. And so we're not guys that say, things seem cheap, we're guys that say, that name seems cheap based on the work we have done.

And then just another question going back to one of your answers to Rick Shane earlier in the call. I think you mentioned how the spread impact is less on those names maturing nearer term and when I look, you have a good slate of names maturing in the next, say, 18 months, one of which was restructured this quarter. So understanding that your portfolio companies are not agented, they're not as fluid on the capital structure side. How do you feel about your deeper vintage and their ability to find financing options before maturity?

So I'm trying to follow the question because it kind of wiggled and waggled. But -- so let me do my best. So first of all, our companies are predominantly, we're the agent on our companies. If you look at the remaining 2014 vintages that are not controlled affiliated investments which we obviously control financing of, that is ScentAir and Insurity. And ScentAir and Insurity are both really good performing names that will have no problem of refinancing. And so there is or my point to Rick was, Rick's question was how I think -- I don't want to put words back into his mouth, but Rick's question was how should we think about the beta, how much beta are you taking up credit mark through your book and is it dollar price, is it spread price, is it duration? And the answer is bottoms up, name by name, and the amount of dollar price movement is a function of the underlying weighted average life of those investments.

And then just one final question, if you don't mind, on the 3% Rule. Do you think that everything just kind of anticipating what kind of comments you might put out and how the community may receive those? Would you say simply that the current proposals are solid except for that the mirror voting stays in place or do you think there's sort of a better way for the community to look at that fund rule reform?

Look, I would say, look, that sector has made great progress in a whole host of areas as it relates to regulation. Obviously the financial flexibility as it relates to the additional leverage I talked about, which is quite frankly creates a ton of value to the sector if they preserve that reinvestment option in a market downturn i.e., they don't get fully levered today. They're making progress in AFFE and 3% Rule has always been top of our issue. So the way we think about the 3% Rule is, not shockingly the industry has been mixed, which I would say the underperformers in the industry have viewed the 3% Rule as kind of a way for them to remain entrenched. And for us, the 3% Rule is simple, which is this sector doesn't have the ability like the rest of sectors to take out excess capacity. And so you end up having in the sector ROE, that the sector trades below book value, the ROE is below the cost of capital, and to me which means the sector has too much capacity and the 3% Rule is the biggest impediment for it to take out capacity because what you would have in any other industry, you saw it from paper and packaging et cetera, you would have would have activism or shareholders' involvement and governance to actually force M&A, the forced rationalization of capacity and you haven't had that in this industry. And so if the 3% rule was changed tomorrow, what I think you would see is behaviors change and capacity come out of the industry and returns go up to the sector because capacity comes out. People buying back shares below book value in size because they will be afraid of shareholders' involvement in the governance process and so you end up having three elements, which is you have the 3% Rule, which you don't really allow for active involvement for shareholders because it's hard to have an active involvement of shareholders, you have the 40 Act rule that relates to voting, so they are terminating management contract is, majority of shareholders which is hard or 66% of the quorum which is impossible and then you have Maryland Law. And so 3% Rule seems like you are not going to change the 40 Act 3% rule seems like the easiest path to take out the excess capacity in the industry. And by the way a lot of the industry is not going to like that.

(Operator Instructions).

Our next question will come from the line of Mark Hughes with SunTrust. Your line is now open.

You had mentioned of the opportunistic investments, you've got the very attractive return. Is this the reason why you don't do more? Is there just the natural higher risk associated with those?

I don't think there is higher risk, it's just tough. Look, it's a tough business to scale in the sense they tend to be a little bit shorter duration and so the impact of our, the percentage of our portfolio will always be smaller given that they tend to be more transitional capital in nature and so the mix is important. What would suspect is that in a time when there is -- in times when there is volatility, hopefully our clients will value certainty, in times where there is real credit issues, opportunistic I think will be a bigger part of our book as long as we provided certainty to our sponsors because they are kind of correlated.

Thank you. And I'm showing no further questions at this time. So now it is my pleasure to hand the conference back over to Joshua Easterly, Chief Executive Officer of TPG Specialty Lending for closing comments or remarks.

Great. Well, look, we appreciate super thoughtful questions on today's call. We really appreciate everybody's participation. Obviously people can reach out to myself, Mike Fishman is here. I didn't give Michael a word today, but Mike is here. You can obviously reach out to Mike, Bo, myself, Ian, Lucy. I want to thank Ian and Lucy for all their efforts in putting this quarter together. Again, thanks everybody, and feel free to reach out. Thanks everyone.

Ladies and gentlemen, thank you for your participation on today's conference. This does conclude our program and we may all disconnect. Everybody have a wonderful day.