Sixth Street Specialty Lending Inc (TSLX) 2022 Q3 法說會逐字稿

Good day, and welcome to the Sixth Street Specialty Lending, Inc. 2022 Earnings Conference Call. (Operator Instructions) Please be advised that today's conference is being recorded.

I would now like to hand the conference over to your speaker, Ms. Cami VanHorn, Head of Investor Relations. Please go ahead.

Thank you. Before we begin today's call, I would like to remind our listeners that remarks made during the call may contain forward-looking statements. Statements other than statements of historical facts made during this call may constitute forward-looking statements, and are not guarantees of future performance or results and involve a number of risks and uncertainties.

Actual results may differ materially from those in the forward-looking statements as a result of a number of factors, including those described from time to time in Sixth Street 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, we issued our earnings press release for the third quarter ended September 30, 2022, and posted a presentation to the Investor Resources section of our website, www.sixthstreetspecialtylending.com. The presentation should be reviewed in conjunction with our Form 10-Q filed yesterday with the SEC. Sixth Street Specialty Lending, Inc.'s earnings release is also available on our website under the Investor Resources section. Unless noted otherwise, all performance figures mentioned in today's prepared remarks are as of and for the third quarter ended September 30, 2022. As a reminder, this call is being recorded for replay purposes.

I will now turn the call over to Joshua Easterly, Chief Executive Officer of Sixth Street Specialty Lending, Inc.

Thank you, Cami. Good morning, everyone, and thank you for joining us. With me today is my partner and our President, Bo Stanley; and our CFO, Ian Simmonds. For our call today, I will review this quarter's results and then pass it over to Bo to discuss our origination activity and portfolio. Ian will review our quarterly financial results in more detail, and I will conclude with final remarks before opening the call to Q&A.

After market close yesterday, we posted third quarter financial results with adjusted net investment income per share of $0.47, corresponding to an annualized return on equity of 11.5% and adjusted net income per share of $0.43, for an annualized return on equity of 10.6%. For the second consecutive quarter, our Board has increased our quarterly base dividend, raising this figure by approximately 7.1% or $0.03 per share to $0.45 per share, to shareholders of record as of December 15 and payable on December 30. By the way, I hope people can hear me now.

This quarter's net investment income and the rise in our base dividend was driven by an increase in the core earnings power of our portfolio. As we previewed in prior quarters, we're now seeing the positive asset sensitivity from higher base rates impacting core earnings. Since we reported last quarter, the forward curve has steepened, resulting in core earnings in excess of what we previously anticipated.

Over the last 5 years, the rolling 4 quarter dividend coverage on our core earnings, core earnings defined as excluding all activity-based income, averaged 102%. At the new quarterly base dividend level of $0.45 per share, we expect our core earnings to exceed this level, and highlights a significant influence that all-in yields have had in the core earnings-generating ability for our portfolio.

Based on the enhanced levels of the dividend coverage that we anticipate extending through 2023, and an understanding of our anticipated leverage levels, our Board felt comfortable raising the quarterly dividend. As the operating environment continues to evolve, the Board will continue to evaluate further increases on a quarterly basis. This is consistent with our philosophy of establishing a base dividend level that we have a high degree of confidence in meeting each period, and maximizing the efficiency of our capital base.

While the base dividend level in Q3 was well covered through core earnings, no supplemental dividend was declared related to Q3 earnings given the NAV limiter in our distribution framework, which serves to retain capital and stabilize net asset value. The revised level of our quarterly base dividend increases the quarterly book dividend yield to 11% from our prior quarterly annualized book dividend yield of 10.3%. Our supplemental dividend framework remains in place, allowing for the opportunity to increase book dividend yields with future supplemental dividends.

Rounding out the earnings summary, the $0.04 per share difference between this quarter's net investment income and net income was due to unrealized losses, primarily from wider market spreads, and not as a result of material changes in the underlying credit quality of our investments. As Bo will discuss, the performance of our portfolio has remained strong.

Growth in our reported net asset value per share from $16.27 to $16.36 was primarily driven by the accretive impact of issuing shares to sell the majority of our 2022 convertible notes, which matured in August. As you may recall from our conference call and the accompanying letter we published last quarter, our valuation framework includes the impact of market spreads movements into the valuation of our portfolio, adjusting for the expected weighted average life and other idiosyncratic factors.

Spread widening and low implied equity values during this quarter resulted in approximately $0.05 per share of unrealized losses, thereby partially offsetting the increase in net asset value we experienced from the combination of accretion from the notes conversion and earnings above our base dividend level.

Turning now to a few thoughts on the current environment. We are 7 months in into the rate hiking cycle, and the Fed has increased rates 300 basis points year-to-date with the expectation of more to come. Despite this being the most rapid rate increasing cycle since the 1970s, it feels like we're in the mid-innings as corporates and consumers, 2 of the 3 main sectors of the economy, remain in a position of strength.

In our view, the key to taming inflation will be real demand destruction, which we anticipate will be long -- which will be a long battle for a number of important reasons. First, overstimulus during the pandemic, coupled with decades of low rates, low inflation and increasing asset prices, has resulted in strong corporate and consumer balance sheets and excess household savings for consumers.

Second, while interest rate increases continue, consumers have been somewhat insulated to date from the immediate impact, as mortgages are fixed in nature rather than floating rate or adjustable and wage growth has remained strong in an environment of historically low unemployment. This latter aspect has helped offset the effect of inflation on the levels of consumption.

Third, given the Fed's ability to pivot is compromised by their need to tame inflation, it seems that the only way to create real demand destruction is through a rise in unemployment, which likely begins once we see a decline in nominal corporate earnings.

As quantitative tightening continues the monetary policy feeds through with its usual lag, the impact of rising rates will be felt differently across asset classes. Risky assets will likely struggle in an environment where the Fed keeps financial conditions tight. Returns for long-duration assets such as tech and biotech equities have been more meaningfully and negatively impacted by movement in rates, as small moves results in large changes to the net present value of future cash flows.

On the other hand, private credit, and more specifically our portfolio, is predominantly comprised of shorter duration assets and not sensitive to change in rates, and less sensitive to widening risk premiums, given the ability to reprice those assets every 2 to 3 years. The benefit to our portfolio of holding floating rate, short duration assets in a rising rate and spread environment is fundamentally dependent, however, upon credit selection and active portfolio management. We believe these factors will ultimately be what drives the dispersion of returns across the sector over time.

Given our track record through COVID, 11 years of investing through SLX and 25 years since our first direct lending investment, we feel well positioned to navigate the uncertain macro environment and take advantage of the opportunity set that it presents.

With that, I'll turn it over to Bo to discuss this quarter's origination activity and portfolio.

Thanks, Josh. Let me first provide our thoughts on the current direct lending environment and how our business is positioned to serve borrowers as well as stakeholders for the period ahead. The volatility experienced across nearly every asset class year-to-date has only underscored the value proposition of private credit for borrowers. New issue leveraged loan volumes were down 86% in Q3 relative to the same period last year, and high-yield volumes yield year-to-date reached its lowest level since 2008.

In addition to the limited number of deals getting done in the public credit markets, we are also seeing a pullback from banks as they focus on satisfying regulatory-driven capital ratio requirements. Given these dynamics, there has been an increasing number of borrowers and sponsors turning to the direct lending market, including those seeking larger financings. We believe this broadening of the opportunity set is a net positive for our sector, and specifically for our business and our stakeholders given our ability to be a solutions provider at scale through co-investments with our affiliated funds.

With fewer financing options available for borrowers, we're seeing a shift towards a more lender-friendly environment. Not only are we seeing higher overall yields driven by higher base rates, spreads have also widened as well. During Q3, LCD first lien and second lien spreads widened by 10 and 152 basis points, respectively. We are also seeing issuers willing to pay higher fees in order to get deals across the finish line, which allows us to pick our spots and remain selective.

With these deal dynamics likely to persist for some time we believe our ability to play offense in this environment, given our strong balance sheet positioning, will allow us to be a valuable partner to our sponsors and management teams in addition to generating attractive risk-adjusted returns for our stakeholders.

While we recognize that the terms are moving in a more lender-friendly direction, there is no free lunch. On the opposite side of the coin, borrowers of many leveraged credit issuers are feeling pressure from sustained inflation, higher interest rates on the debt obligations and a very tight labor market. Similar to our approach during COVID, we are actively monitoring our portfolio companies by staying in close communication with management teams, so we're able to respond quickly when necessary if credit quality issues look likely to arise.

Based on the ongoing real-time conversations we're having with our borrowers, however, we feel very good about the health and positioning of our current portfolio as we continue to be largely invested at the top of the capital structure in software and business services sector that provide mission-critical products and solutions to their customers.

Moving to originations activity. We had $385 million of commitments and $274 million of fundings across 7 new investments, 6 upsizes to existing portfolio companies and some small incremental allocations to structured credit investments during the quarter. We've mentioned in prior quarters that our pipeline was building leading into the back half of the year. And this quarter's new funding, along with our expectations for Q4 funding activities, continue to support that view.

Several of our new investments in Q3 reflected the evolution we're seeing in the direct lending market of larger financings, as fewer borrowers are able to access the traditional BSL market to meet their capital requirements.

In August, we agented and closed a $375 million term loan commitment to support an operational turnaround by Bed Bath & Beyond. As access to traditional sources of capital has become more constrained, our ability to invest alongside affiliated funds allowed us to be a valuable solutions provider for the company during a time of need.

Given the transactional complexity, we were able to drive better pricing and terms, which supports robust asset level yields. Additionally, our expertise in the retail ABL space allowed us to underwrite the investment with speed and certainty based on our years of experience executing on this theme. Since commencing investment operations, Bed Bath & Beyond represents the 25th retail ABL transaction that we've completed, with a total of $1.1 billion of capital deployed in SLX through the strategy. At quarter end, our retail ABL exposure increased to 8.4% of the portfolio on a fair value basis.

Also this quarter, alongside affiliated funds, we agented and closed a $535 million senior secured credit facility to support Bain Capital's acquisition of LeanTaaS. We believe that Bed Bath and LeanTaaS are both examples of how the scale of the Sixth Street platform allows us to source and underwrite strong risk-adjusted returns across both the sponsored and nonsponsored landscape.

Our investment thesis in LeanTaaS was supported by an inherently sticky underlying product in the software space, resulting in high-quality recurring revenue base that is increasingly important in this current environment. This investment reflects our continued focus on software and business services themes that comprises 78% of our portfolio on a fair value basis at quarter end. Given our familiarity in the space and our balance sheet flexibility, we're able to provide a level of deal customization that sets us apart from our competition.

On the repayment side, wider spreads have led to a slowdown in refinancing activity, resulting in less portfolio turnover over the last couple of quarters. We had 1 full and 1 partial investment realization totaling approximately $16 million in Q3. Our full investment realization of Mississippi Resources was related to the proceeds available from dissolving the business. We received our final distribution at the end of September, and the remaining debt was repaid, resulting in a small realized gain. Since quarter end, Frontline and BioHaven, our 2 largest portfolio companies based on fair value as of 9/30, were repaid during the first week of October, driven by previously announced M&A.

As of quarter end, our weighted average mark on BioHaven was 110, reflecting the impact of the anticipated fees embedded in our underlying exposure to this portfolio company, that has since been crystallized in $0.11 per share of activity-based fees, which will flow through to investment income in Q4.

Our weighted average yield on debt and income-producing securities at amortized cost was up to 12.2% from 10.9% quarter-over-quarter and is up about 200 basis points from a year ago. The weighted average yield and amortized cost on new investments, including upsizes this quarter, was 12.6% compared to a yield of 10% on investments partially paid down.

Moving on to portfolio composition and credit stats across our core borrowers from whom these metrics are relevant, we continue to have a conservative weighted average attach and detach point on our loans at 1x and 4.4x, respectively, and their weighted average interest coverage remained stable at 2.6x. As of Q3 2022, the weighted average revenue and EBITDA of our core portfolio companies was $149 million and $44 million, respectively.

The performance rating of our portfolio continues to be strong, with a weighted average rating of 1.12 on a scale of 1 to 5 with 1 being the strongest, representing a positive change from last quarter's rating of 1.13. After the realization of Mississippi Resources during the quarter, we have only 1 portfolio company on nonaccrual representing less than 0.01% of the portfolio at fair value, with no new names added to nonaccrual during Q3. The strength and improvement of these metrics quarter-over-quarter illustrates our confidence in the underlying credit quality of our portfolio.

With that, I'd like to turn it over to Ian to cover this quarter's financial results in more detail.

Thank you, Bo. For Q3, we generated adjusted net investment income per share of $0.47 and adjusted net income per share of $0.43. At quarter end, total investments reached $2.8 billion, up from $2.5 billion in the prior quarter as a result of net funding activity.

Total principal debt outstanding at quarter end was $1.5 billion and net assets were $1.3 billion or $16.36 per share. Our average debt-to-equity ratio increased quarter-over-quarter from 0.9x to 1.15x, and our debt-to-equity ratio at September 30 was 1.16x. The increase was driven by portfolio growth from new investments during the quarter combined with minimal repayment activity.

As Bo previewed, the repayment activity we experienced in the first week of Q4 brought our debt-to-equity ratio down to approximately 1.05x. Before diving into more detail on our quarterly results, I would like to highlight the strength of our liquidity, funding profile and capital position. As we head into the remainder of the year our liquidity position remains robust, with $846 million of unfunded revolver capacity at quarter end against $184 million of unfunded portfolio company commitments eligible to be drawn. And our funding mix at quarter end comprised 52% unsecured debt and 48% secured debt.

Our balance sheet positioning was further enhanced post quarter end from the payoff of our positions in BioHaven and Frontline, totaling approximately $146 million. Pro forma for these payoffs, which were the 2 largest positions in our portfolio at quarter end, we have close to $1 billion of liquidity.

On top of the activity-based fees earned, these payoffs also increased our capital base by creating incremental investment capacity for new deployment opportunities into a more appealing investment environment. The accretive equity issuance that occurred at the beginning of August relating to the conversion of maturing convertible notes resulted in the issuance of approximately 4.4 million shares, providing us with additional balance sheet flexibility during a time when capital has generally become more constrained across the sector.

One aspect of our balance sheet that is different this quarter is that we no longer show a dividend payable at quarter end. This is as a result of the change we discussed on our last quarterly earnings call to bring forward the payment date of our quarterly base dividend to occur on the last business day of the quarter. The most recent base dividend payment date was September 30. Hence the dividend that had previously been declared for Q3 dividends was paid to shareholders. That will be the case in future periods as well.

During September, our 10b5-1 stock repurchase program was triggered, resulting in repurchases of $3 million, which represents approximately 180,000 shares at an average price of $16.62. The existence of this program is consistent with our objective of allocating capital to accretive opportunities for our shareholders, and we will continue to prioritize capital efficiencies throughout this ongoing volatile and uncertain environment. Yesterday, our Board renewed this program and reset the total size to $50 million.

Given the premium on capital availability and the more compelling new investment environment that Bo spoke about earlier, our program trigger will be reset to activate at $0.01 below the most recent reported net asset value per share.

Moving to our presentation materials. Slide 8 contains this quarter's NAV bridge. Walking through the main drivers of NAV growth, we added $0.47 per share from adjusted net investment income against our base dividend of $0.42 per share. There was a positive $0.08 per share impact from the conversion of the convertible notes that was settled primarily through an equity issuance above net asset value. There were negative impacts from changes in credit spreads on the valuation of our portfolio amounting to $0.05 per share. And finally, movement in foreign exchange rates drove unrealized losses on our foreign currency denominated investments, which were offset by unrealized gains on our foreign currency denominated debt outstanding.

It's worth spending a moment on the financial statement presentation of our foreign currency-denominated investments, as this can cause some confusion. Our philosophy when funding foreign currency investments is to borrow the par amount of that investment in local currency through our multicurrency revolving credit facility. This gives us both an asset and a liability denominated in local currency. Therefore, any movement in the FX rates applying to that investment impacts both the asset side and the liability side of our balance sheet in an equal but offsetting way.

In the schedule of investments, depending on the movement of the relevant foreign currency relative to the U.S. dollar, this can appear as though the valuation mark has declined when the U.S. dollar strengthens. However, it's important to note that movement in the fair market value of an investment due to changes in foreign currency rates is distinct and separate from a change in the valuation mark caused by credit or widening spreads.

Looking at the limited number of foreign currency-denominated investments we hold in isolation without including the offsetting impact from the foreign currency liability can therefore lead to an incorrect conclusion. To use a specific example, let's look at a Canadian borrower in our schedule of investments, Acceo Solutions, Inc., where we hold a first lien term loan.

The valuation mark at quarter end is 101.0. At the end of Q2, the valuation mark on Acceo was 101.25. So from a credit perspective, there's been very limited movement quarter-on-quarter. Over that same period, however, the fair market value as a percentage of cost has fallen from 104.2 to 97.5, representing a significantly larger decrease in value than that represented by the limited decrease in the valuation mark. For Acceo, this divergence was the impact of the strengthening U.S. dollar over the period.

Taking into account our natural hedge created by borrowing in local currency, the value of our Canadian dollar debt, expressed in U.S. dollars terms, decreased in an equal and offsetting way over the same period. At quarter end, the fair value of our foreign currency-denominated investments represented approximately 4.6% of our portfolio. None of those investments are on nonaccrual status, and each of the investments was rated 1, consistent with that of the overall portfolio that Bo referenced earlier.

Now for our operating results detailed on Slide 9. Total investment income for the quarter was $77.8 million, up 22% from $69.3 million in the prior quarter, driven by increased all-in yields and net funding activity. Walking through the components of the income, interest and dividend income was $74.7 million, up 26% from the prior quarter. Other fees, representing prepayment fees and accelerated amortization of upfront fees from unscheduled paydowns, were lower at $429,000 compared to $3.2 million in Q2 given the lower impact on income measures from repayment activity that we highlighted earlier.

Other income was $2.7 million, up from $1.6 million in the prior quarter. Net expenses, excluding the impact of the noncash reversal unwind of capital gains incentive fees were $40.3 million, up from $31.4 million in the prior quarter. This was primarily due to higher interest expense on higher average outstanding indebtedness, the upward movement in reference rates, which increased our weighted average interest rate on average debt outstanding from 3.1% to 4.3%, and higher incentive fees as a result of this quarter's overearning.

Before turning it back to Josh, I'd like to briefly provide an update on our ROEs. The 2 main drivers of our outperformance on an ROE basis have been the strength of our all-in yield on assets and our ability to avoid credit losses since inception. We have actually generated net realized capital gains. At the beginning of this year, we communicated an annualized ROE target of 11% to 11.5% based on our expectations over the intermediate term for our net asset level yields, cost of funds and financial leverage.

Year-to-date, we've generated an annualized ROE on adjusted net investment income of 11%. Given the strength of our investment pipeline, continued positive impact from higher all-in yields and our expectations for fee-related activity for the remainder of the year, including the $0.11 per share of fees that were crystallized in October from the payoff of BioHaven that we mentioned earlier, we believe we are on pace to exceed the top end of our previously stated target range for 2022 NII per share of $1.84 to $1.92. This implies Q4 NII in excess of $0.54 per share and a full year ROE on adjusted net investment income of greater than 11.5%.

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

Thank you, Ian. As we all know, periods of economic uncertainty present both significant risks and significant opportunities. On the opportunity side, these movements of volatility and market dislocation result in a shift away in the opportunity set from M&A to an opportunity set that requires private capital to be creative solution providers.

Given our capabilities and expertise in the specialty lending situations, we believe we have built an all-cycle business model that is well-positioned to take advantage of this shift in the operating landscape. We know that the best vintages are often underwritten in these times of uncertainty, and we're ready to take advantage of the opportunity set ahead.

Although I shared bearish views on the broader macroeconomic backdrop, I remain bullish in our ability to underwrite robust risk-adjusted asset level returns and generate strong, consistent return on ROEs for our stakeholders. Over the last 5 years, a largely benign credit environment still resulted in a wide dispersion in returns generated by managers in this sector, mostly driven by dispersion in credit costs. This is evidenced by the net realized losses of 100 to 150 basis points on an annualized basis in the sector, based on Cliffwater's Direct Lending Index over the trailing 5-year period through Q2 2022, compared to net realized gains for SLX over the same period. We believe that this dispersion will only expand as the operating backdrop becomes more complex.

As rates continue to rise, managers spend a lot of time talking about the impact from increasing rates and asset sensitivity. While rising rates will be beneficial to the sector in the near term, long-term outperformance is ultimately driven by the ability to avoid credit costs through the cycle. We believe we will continue to achieve this by following our same playbook that resulted in cumulative net realized gains since inception.

As 1 of our favorite bands once put it, nothing else matters. I'm sure Metallica will appreciate the callout on our earnings call today. As the year is coming to an end, I want to wish everyone a wonderful holiday season ahead with their friends and loved ones. We look forward to a busy and productive remainder of the year, and thank you for your continued support throughout the uncertain world we're living in today.

Operator, please open up the line for questions.

(Operator Instructions) Our first question will come from Jordan Wathen or Finian O'Shea with Wells Fargo.

It's Jordan on the line for Fin today. You mentioned LeanTaaS in your prepared remarks. We noticed that had a bigger chunk of delayed draws versus funded this quarter. And we've heard that the delayed draws have kind of been harder to come by for borrowers. So I'm just curious on how you characterize that. Are you -- is that a way for you to compete on terms? Are you picking up more economics for making that extension here in the present? And just any color you could add on that?

Thanks, and tell Fin hello for us. And again, sorry for the technical difficulties this morning. I think that was idiosyncratic to LeanTaaS. I think part of it was driven by competition and structuring considerations. I think the general comment that delayed draw term loans are more difficult in this environment to come by is most definitely true. That transaction was earlier in the pipeline. And quite frankly, for us, I think in this environment, we'd rather hold less unfunded forward commitments and drive to fundings, to drive economics in this environment. So I think that the observation was true. That deal was -- there was some idiosyncratic considerations and it was much earlier in the pipeline and the environment.

Okay. And then just more generally on the market. We just saw with Emerson, a deal that kind of more closely matched the old school bank first lien and private -- where a private credit kind of took the back seat behind the banks. So for your [stories]...

This is the wrong assumption. The Emerson Term loan A and Term loan B are pari passu. And so there is no back seat to the banks. I think that was a -- the wrong conclusion. It's not a silo, it's not a first lien, second lien. It's pari passu capital where the banks are holding it on balance sheet. And basically, the only difference is amortization, but it's pari passu in the capital structure, with the Term Loan B having a much higher spread [to] the private credit markets.

And so I think Blackstone was -- figured out a way to effectively use their relationships with banks to where they could figure out how banks could have, given some amortization, have a piece of paper that worked for them in this environment given returns on capital, and then the marginal capital from the private credit market, which was pari passu priced much wider. So I think the assumption is a false assumption, which is that it's not back fee, it's not a silo, it's all pari passu debt.

No, that's good to hear. Thanks for clarifying that.

And 1 moment for our next question and that will come from the line of Kevin Fultz with JMP Securities.

Bo touched on this a bit in his prepared remarks, but I just want to dig in a bit into the investment landscape a bit more. Given the evolution of market conditions over the past 2 to 3 quarters, I'm curious if you could talk about how that's translated to deal pricing, leverage or improved documentation in deals that you're originating right now compared to 6 to 12 months ago?

Yes. Look, I'll let Bo handle -- let me hit on Emerson because I think Emerson is a great example of that. My -- not to get into details, but in the general direction, that Term Loan B on Emerson, my guess would have been in a broadly syndicated market, it is an unbelievable good credit, and with a good capital structure, it probably would have had 2 to 2.5 turns wider of first lien debt and would have been priced 300 basis points tighter compared to the Term Loan B.

And so just on Emerson, that first lien [will had] 2 to 2.5 turns less of debt with significantly wider pricing, that to me is a really good example of really tightening underwriting standards and wider spread. And again, the marginal capital in that deal was the private credit market, which really drove returns in this market. So Bo, I don't know if you have anything to add.

No, that's spot on. We continue to see support for better underwriting standards in the form of higher spreads. I think those higher spreads are anywhere in the range from 100 to 200 basis points plus from what we saw for comparable businesses just 6 to 12 months ago. You're seeing also a turn to 2 turns of leverage come down and better documentation in the form of less leakage, inability to layer in more debt, et cetera. So all across the board, you're seeing stronger underwriting standards, particularly in this larger end of the market.

Okay. That's really helpful color. And then just 1 more, if I can. You were relatively active again this quarter investing in CLO notes. Clearly, it's a small portion of the portfolio in aggregate, but still 1 that's growing. Can you talk a bit about the opportunity you're seeing investing in CLOs, how much capital you're willing to put to work there? And if you view these investments as buy and hold or more short term in nature?

We've always used it as a -- we're not traders. We've always used it as a barometer for relative value. We still think there's really strong relative value given the loss-taking ability [in] CLOs which imply people lose money where we're investing in those securities. You have to have like 1.5 to 2x cumulative default that you saw in the global financial crisis. And they're BB to BBB securities that yield similar to -- when you think about with the discount -- similar to private credit. So we think that is a great relative value investment. And again, it's a relatively small part of our portfolio, a relatively small part of our portfolio.

Okay. I'll leave it there. Congratulations on the quarter.

One moment for our next question. And that will come from the line of Ken Lee with RBC Capital Markets.

You mentioned in the prepared remarks, having constant conversations with the portfolio company management teams. Wondering if you could just talk a little bit more about what you're seeing in terms of any kind of amendment activity in the most recent quarter?

Yes. It's Josh. Look, we -- the great thing about private credit is you get to have these dialogues. We had no material amendment activity this quarter. And so it's been -- it was a really, really benign, the portfolio is in really, really good shape. It is a -- it was a very, very benign levels of activity on the amendments and waivers. And I think that speaks to the portfolio and that quality of portfolio, which we've built, which mostly is when you think about the nature of our business, I think like 78% to 80% has been -- of existing portfolio relates to software and business services that have recurring revenue and variable cost structures. And so it was a, again, no material amendments and waivers this quarter.

Got you. Very helpful. And just 1 follow-up, if I may. In terms of the debt paydowns, you saw a slowdown in the quarter and you cited just the environment driving that. What -- in your view, what could potentially drive a potential pickup in terms of paydown activity at some point? Or would you expect relatively dampened activity just in the near term, given the macro backdrop?

Yes. Thanks, Ken. So let me answer your question. I think this is a really important thing for people to understand. Look, paydowns typically drive activity-based income. And that tends to be lumpy over the year or quarter-over-quarter. We had 2 large paydowns at the end of the quarter -- at the -- sorry, the beginning of Q4, which was literally, I think, October 1 or October 3 or 4, but right the first week of October.

BioHaven, that will drive about $0.11 per share of activity-based income in the Q4 earnings. By the way, that could happen in Q3, right, so it's really hard to tell when that happens. But this has most definitely been a benign, not shockingly, a benign year for portfolio turnover given the widening credit spread environment.

And so what you would typically see is in a widening -- a tightening credit spread environment or an environment where you have looser underwriting standards, which I think means lower volatility and -- or lower macro volatility, that you will see the portfolio churn pick up.

The last point I would make is the -- historically, we've earned somewhere between 98% to 105% of (technical difficulty) dividend coverage from core earnings. When we define core earnings, I think that's different than what other people do in the industry like Ares, where we define it as just really interest income and interest income from regular amortization of OID. And that's been 98% to 102% coverage on our dividend. I think in the -- with the increased raise of our dividend by 7%, our coverage is actually greater than our historical environment from core just pure interest income.

So I think in an environment where activity levels pick up, we will have -- we're pretty well situated given where our balance sheet leverage is to continue to drive interest income that well feeds our new dividend plus we'll have income from activity levels. But that's going to happen in an environment where you have tightening spreads, looser underwriting standards.

And then I think specific to us, given some of our business is more specialist situations, and specialty lending oriented, that part of the portfolio constantly churns no matter what environment you're in. So hopefully, that was a long-winded way to answer your question, but I wanted to use the opportunity to give you the full picture of the earnings -- the increased earning power of the business and what really drives income and return on equity for the business.

No, that was great. That was great color there and really appreciate the answer there.

One moment for our next question. And that will come from the line of Melissa Wedel from JPMorgan.

Appreciate you taking my questions today. I was curious to get your thoughts on sort of the supply side in private credit. You talked about the increase in demand that you've seen for private credit solutions in this environment. I know in the last few years, there's been a lot of capital formation within the private credit space. At this point, have you seen a lot of that capital deployed? Or is there still a lot of competition, I'm also curious for that.

Yes. So look, the way I would frame it is, and it's pretty clear the check sizes have come significantly down for some large private credit investors in the space. And so you once saw people writing $500 million to $2 billion checks that are writing significantly less today. And so I would say the -- we live in a market where that -- on a go-forward basis where the demand for credit will be somewhat less, and that opportunity set is changing. So it's changing from M&A and buyout and recaps to -- there will be still some of that, but to really to kind of our core specialty lending aspect and the supply of private credit is also coming significantly down.

And so you have seen wider spreads and tightening underwriting standards. And so I think there is -- as the economy shrinks or stagnates a little bit, the demand for credit will obviously be less. But you also have seen the supply shrink. And you've seen that -- and if you think about it in the equilibrium of that, you see that in widening spreads and tightening underwriting standards. And so I think that's a function of mostly the supply side and because the demand side, M&A is down, the demand side shrinking as well. So hopefully, that answers it.

No, that's helpful. Appreciate that. And if we could pivot for a moment to sort of your ABL strategy. I know you touched on 1 investment that you made during the third quarter, definitely sort of a follow-on from investments that you've made in the past. So when I think back to when you last were really involved -- actively involved in originating ABL investments, it was a bit of a different environment in a lot of ways, but particularly with regard to inflation. I'm curious if you have to evolve your underwriting or how you approach ABL in a higher inflationary environment?

Yes, it's a great question. So a little history on our ABL. Look, this is a business we know very, very well. Specifically on Bed Bath & Beyond, I think that speaks volumes about our platform, which was -- and it didn't show up as that material in our P&L, but we originated that investment and sold it above our cost, increased syndication income for SLX this quarter. So the -- our ability to deliver the entire platform, to deliver [in] size to an issuer with certainty allowed us to create additional economics [and] something that [worth] more than costs for our investors.

So like I think people should understand that. I think the environment has most definitely changed. The great thing about those types of structures and loans is that we get to evaluate the value of our collateral in the environment that we're in today, where if there's margin compression, the value of that inventory goes down. And so -- and which means what we actually lend on that collateral goes down.

And so it's a pretty dynamic way to approach the market. And we -- again, we've been in this market for 20-plus years, and we've invested across the cycles, and you most definitely have to be macro aware. That being said, there is a mechanism in how we structure these deals and how we think about it, which allows us to adjust our risk dynamically. Is that fair, Mike?

Yes. No, I agree.

And the good news is, I think that opportunity set is only getting bigger, which is post COVID, when you think about the world, consumers had a lot of dollars in their pocket. They couldn't spend money on activities or vacations. So they bought goods which created an environment where retailers had really, really good balance sheets, high gross margin, high EBITDA margins and that's kind of reversing. And so I think our capital in this environment will be very, very valuable.

(Operator Instructions) One moment for our next question. That will come from the line of Robert Dodd with Raymond James.

And I think, honestly, you partially answered this in the [swat similar so]. When we look at the portfolio, kind of the mix of the structure of loans going forward, I mean do you expect highly structured loans, be it ABL debt, whatever, like those special situations. Do you expect that to be a growing portion of the portfolio over the next, call it, 18 months, 24 months, whatever it is, however long this rate cycle goes? Given in context, obviously, a more "conventional" loan like Emerson. It's got better leverage, it's got better yield or better spread. But structurally, I think it would be classified as more conventional. So do you expect that -- the attractiveness of those normal loans with high yields to be competitive with some of the special situations kind of things that you do? Or how do you think that mix in the portfolio is going to evolve over the next couple of years? Because to be blunt, a lot of your excess ROE comes from those activity fees on the special sits kind of things you've done to start.

Yes. Look, I think post COVID, where the world was flush with liquidity and corporates and retail again, had really good balance sheets, they didn't need our capital. And that's been historically a 20% growth unlevered return for us. And so when you think about the total return for that business.

So -- and I agree with you, a lot of our excess has come from those type of businesses or those types of situations like Ferrellgas, the retail ABL stuff. There's been Metallco -- like there's been a lot of those. So I expect it actually to massively increase in this environment going forward as credit availability dries up and there's demand destruction and corporate balance sheets get in a much more difficult position. I think there's going to be a lot of opportunity where we can bring the expertise of our platform, both from an industry and product standpoint, to be a solution provider that will drive excess returns for SLX shareholders.

That, I think, is the single most valuable thing about our business, which is we get to invest across cycles and take high relative value from a risk-adjusted return perspective, and our shareholders benefit from that. And so I most definitely think it's going to increase. Historically it's been about 40% of our originations, but it's been a much smaller part of our portfolio [due to] that portfolio churns quicker.

I think that there's going to be most definitely a shift. And -- but it requires a different type of platform and -- which is a platform that -- it's our platform -- this environment is built for our platform, which is we are able to navigate complexity and create good risk-adjusted returns for our stakeholders in a way where other platforms are set up just to do sponsor business and are long the M&A environment are unable to do. So this is -- I couldn't be more excited about the opportunity set going forward. And by the way, we'll do both, but we have the opportunity to pick the highest risk-adjusted returns and drive return on equity for our shareholders, because the top of our funnel is much broader. And so we have a broader view of the world. You're most definitely onto something, Robert.

Okay. I appreciate that. The follow-up to that, if I can, real quick. Given -- I mean, you have that expertise on the platform, et cetera. Have you seen any increase in poaching efforts? I mean, is that -- given as the market gets more troubled then your platform has disproportionate expertise in some of these other things. Has there been an attempt to poach more of your staff? How are you -- if it's not happening, you don't have to deal with it. But if that has happened, can you give us any color there?

No. Look, we haven't -- and what I would say is that I think it culturally takes a different mindset. Just like there are -- I'm not going to go platform by platform or name by name, but like there is a cultural difference because on the -- where you have complexity requires private equity-style due diligence, real deep negotiation on docs, a real hand-to-hand combat.

And quite frankly, I would say it's less profitable to the GP in the sense that it takes more people and more time and you don't get to keep an asset as long. And so I think people make economic choices. We try to make economic choices just in light of our shareholders and stakeholders.

And I think that there are cultural issues as it relates to like getting into this business, because it's not like a sponsor is giving you a cap structure and all their due diligence. It's a really different business. So we haven't seen it. This is, again, the 1 thing I love about our platform that we've built is I feel like we can be [ranging] across cycles to really create value. And I would say there are some platforms that can do it, but a lot of the traditional sponsor-based platforms, they're not built culturally to do this. They made different economic choices. And so we haven't seen it.

One moment for our next question. That will come from the line of Ryan Lynch with KBW.

The question that I had is just related to your interest coverage and your software portfolio. As I kind of think about -- historically, as I think about kind of software investments, I typically think because they're more resilient businesses for an economic downturn, they typically have higher purchase price multiples and corresponding higher leverage levels, though, that come with those investments. Obviously, you may disagree with that.

But if that assumption is correct, how should we think about and how are you guys viewing interest coverage and the ability for those borrowers to withstand higher interest rates from basically 0 to 4% or 5% likely next year if some of those businesses while, I think are structurally stronger businesses than more resilient businesses, might have more leverage than maybe an average company.

Yes. Great. Great question. So I'm not sure they have in our portfolio that much more leverage, but [the summary] of your premise is correct. First of all, interest coverage in our portfolio, I think, is flat quarter-over-quarter on a LTM basis. So we haven't seen degradation in interest coverage, which means that management teams were able to push through pricing or change cost structures. And the great thing about software businesses, they tend to be 80% to 85% gross margin businesses and have variable cost structures beneath that.

And so they -- and their revenues are typically known. So when we look at the health of our software portfolio, just to go through because I think it is helpful, and we try to look at KPIs that are that more forward leaning about the health of the business. So just to give you a couple of statistics, revenue grew quarter-over-quarter -- about 6% quarter-over-quarter and year-over-year about 17%.

And then when you look at retention in that business, and retention is a really big driver of forward revenue, retention in Q2 was 90% gross, that was before upsells, et cetera, and 105% net. And pretty much that same range, 91% gross and 103% to 104% net in Q2.

And so the fundamentals of our software business, interest coverage has remained pretty -- has been the same quarter over quarter, and the fundamentals in the software business has been really, really good.

And when you think about the great thing about that business is they are literally -- when you look at the customer base on a same-store basis, their customer base is growing -- they don't have to do anything -- between people buying new products and pricing. And so I feel really good about how we're positioned. And it shows up both on a forward perspective, when you look at the KPIs of the business that are forward indicators, and interest coverage, which is in a historical perspective, and it shows up there as well.

So I like the defensive nature of how we're positioned currently and I think it's showing through in the fundamentals of the book. Bo, do you have anything to add on that?

No, I think that said it. Also, as I mentioned in the earnings call, our detach points have remained stable at 4.4x. That's across all borrowers, but we feel very good about the health of that software portfolio and the core earnings power.

That's helpful. And I really do appreciate the specific statistics that you provided on how the software portfolio is performing. Do you -- can you provide the overall interest coverage? I know you said that didn't change in the trailing 12 months this quarter. But what is the overall interest coverage in your portfolio?

2.6x.

Okay. Yes. So it's pretty healthy.

And speakers, I'm showing no further questions in the queue at this time. I'll turn the call back over to management for any closing remarks.

Great. Thank you again for the technical difficulties earlier. I appreciate you hanging in for those 30 seconds that seemed like a lifetime. I hope everybody has a happy Thanksgiving and a holiday season. We'll continue working very, very hard. We think the environment is really interesting for our skill sets and capital -- type of capital. And we look forward to chatting in the future. Thanks.

Thanks, everyone.

Goodbye. This concludes today's conference call. Thank you for participating. You may now disconnect.