Sixth Street Specialty Lending Inc (TSLX) 2022 Q1 法說會逐字稿

Ladies and gentlemen, thank you for standing by, and welcome to the Sixth Street Specialty Lending, Inc. Q1 2022 Earnings Conference Call. (Operator Instructions) Please be advised that today's conference is being recorded. (Operator Instructions) 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 first quarter ended March 31, 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 press 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 fourth -- first quarter ended March 31, 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. Good morning, everyone, and thank you for joining us. With us today is my partner and our President, Bo Stanley; and our CFO, Ian Simmonds.

For our call today, I will provide some highlights of this quarter's results and pass it over to Bo to discuss this quarter's 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 for Q&A.

After market closed yesterday, we reported first quarter financial results and adjusted net investment income per share of $0.49, corresponding to an annualized return on equity of 11.6% and adjusted net income per share of $0.56, corresponding to an annualized return on equity of 13.2%.

As discussed in previous quarters, at quarter end, we had approximately $0.21 per share of cumulative accrued capital gains incentive fees on the balance sheet. Approximately $0.13 per share of this amount would be payable in cash if our entire portfolio were to be realized at the quarter end mark in normal course.

The remainder of the accrued fees are tied to unrealized gains through the valuation of our net investments, inclusive of call protection, which if prepaid, would recognize -- would require recognition of fees and investment income and trigger a reversal of previously accrued capital gains incentive fees related to these investments.

This noncash expense, which was not paid or payable, was approximately $0.02 per share for Q1. From a reporting perspective, our Q1 net investment income and net income per share includes some of these accrued capital gains incentive fees, expenses, was $0.47 and $0.54, respectively.

This quarter's net investment income reflects continued strength in our core earnings power of our portfolio, above the guidance we provided in our last earnings call. Net investment income was supported by fee income from portfolio activity, alongside interest and dividend income levels driven by sustained portfolio yields. The difference between this quarter's net investment income and net income was a result of net unrealized gains primarily from portfolio company-specific events.

Looking ahead, we are facing an operating environment which has changed significantly over the last few months. The increase in inflation, rising interest rates, geopolitical factors and the lingering impacts from the global pandemic will certainly present a headwind for the U.S. and global economy.

However, similar to our positioning heading into the uncertainty of COVID in early 2020, we have invested in high-quality, durable businesses on the asset side and maintained a disciplined approach to building and maintaining liquidity, inclusive of the understanding of our unfunded commitments on the liabilities side. We further enhanced our liquidity profile during the quarter through an extension and expansion of our existing revolving credit facility, which Ian will discuss in further detail later on the call.

From a macroeconomic perspective, the impact of the interest rate environment is on top of mind. Although we saw meaningful upward movement in interest rates during Q1, we haven't seen the impact yet on our financial results for 2 primary reasons. On the asset side, the floors on our debt investments act as downside protection of a falling rate environment, which we have seen up until recently.

In a rising environment, as we experienced in Q1, our floors mask the impact of the increase until reference rates rise above our average floor levels. Once through our floors, we're able to benefit from the asset sensitivity of our matched floating rate exposures.

On the liabilities side, our weighted average cost of debt outstanding remained relatively flat this quarter given the mechanics of how to swap contracts on unsecured liabilities are reset at the end of the preceding quarter, resulting in a 1 quarter lag of rising rates impacting our income statement. Given the speed for which interest rates have risen to date, the increase we expect to see in our weighted average cost of debt will be offset from the asset side as reference rates rise further above our average floors in 2022.

Although we anticipate the rising interest rate environment to play out favorably as a lender positioned to benefit from the positive asset sensitivity of our balance sheet, we also are very cognizant of the potential impacts on our borrowers. To date, interest coverage remains strong across our portfolio of companies, and we are confident in the credit quality we have underwritten.

As we've said in the past, we are focused on investing at the top of the capital structure, in high-quality businesses in industries that we like and know well.

At quarter end, net asset value per share was $16.88, up $0.15 per share or 1% from pro-forma net asset value at -- per share at year-end of $16.73. This growth was primarily driven by continued over earning of our base dividend and net unrealized and realized gains from investments.

Over the trailing 2-year period, reported net asset value has increased by 8.4% and a total of $5.94 of distributions have been distributed, resulting in total economic return on book value of about 46.5%. Yesterday, our Board approved a base quarterly dividend of $0.41 per share to shareholders of record as of June 15, payable on July 15. Our Board also declared a supplemental dividend of $0.04 per share, relating to our Q1 earnings -- related to our Q1 earnings to shareholders of record as of May 31, payable on June 30.

Our Q1 '22 net asset value per share pro forma for the impact of the supplemental dividend is $16.84. We estimate our spillover income per share was approximately $0.59.

Before I pass it over to Bo, I wanted to note, on April 8, Fitch Ratings agency published their annual review of BDC sectors -- the BDC sector. We are pleased to share Sixth Street Specialty Lending received a 1 notch ratings upgrade from BBB- to BBB flat, with a stable outlook.

Of the 16 firms in their rating universe, TSLX was the only firm to receive such an upgrade and is only 1 of 2 BDCs to hold a rating from Fitch. As Fitch reported, the upgraded affirms over a decade's worth of strong and consistent performance and is supported by our sector-leading returns.

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

Thanks, Josh. I would like to start by sharing some observations on the broader market backdrop, in particular, the inflationary environment and upward movement in rates since our last earnings call in February.

These macroeconomic factors, coupled with Russia's invasion of Ukraine, led to heightened volatility and uncertainty in the financial markets during the quarter. Public markets reacted quickly, with equities and high-yield ending the quarter down 4.5% for the S&P 500 and 4.6% for the U.S. High Yield Index, representing their worst quarter since Q1 of 2020. These fluctuations in the public markets ultimately led to a period of price discovery for private buyers and sellers, resulting in a slowdown in M&A activity in Q1.

As we had expected, decline in M&A activity was matched with muted leverage loan volume relative to historical periods. These trends carried across the middle markets, where new-issue loan volumes were down 51% from a year ago. Loan volumes were also driven by issuers taking time to reconsider the immediacy of their capital needs, reflecting the widening of first-lien and second-lien spreads by a peak of 47 and 124 basis points, respectively, through mid-March.

By quarter end, there were some reversion of spread movement, with first-lien and second-lien spreads, 31 and 5 basis points tighter than they wides, respectively. With more volatility likely ahead, we expect to see borrowers looking to the private markets as an alternative to traditional capital markets, leading to opportunities where we can provide our differentiated capital solutions and expertise.

Pivoting now to the inflationary environment, if we take a step back and look at what is driving the price increases, much of this can be explained by the scarcity of certain goods, raw materials and commodities. Over the last 6 to 12 months, we've seen the impact across several sectors, such as real estate, automotive and energy, as demand has exceeded supply in these industries, driving up prices for the consumer.

Given we have low exposure to these industries and are heavily weighted towards software and business services, we generally haven't seen margin compressions or supply chain issues thus far impacting our portfolio of companies.

Demand has also been strong as the consumer sector has benefited from high wage growth and prior fiscal transfers from government support provided throughout COVID. Household wealth has soared on the back of strong house price increases and prior equity gains. With rent growth and demand for services increasing post-COVID, the longevity of higher inflation will be -- that higher inflation will be key to the outlook. We continue to monitor and construct our portfolio with inflationary pressures in mind.

Turning to the portfolio activity. Our commitments and fundings slowed in Q1 after a busy 2021, totaling $79.3 million and $52.8 million, respectively. This was distributed across 2 new and 8 upsizes to existing portfolio of companies. Our new investments this quarter were both first-lien loans in the software services space in businesses providing value-added technology and solutions.

We were also active during the quarter by supporting our existing portfolio of companies on their strategic growth and capital needs. Including our new investments in Lucidworks, 71% of this quarter's funding served our existing borrowers.

In terms of new borrowers, we closed a $130 million senior secured financing, alongside Sixth Street's European direct lending fund, to support the acquisition of Unily by CVC Growth. Unily is a provider of employee experience software, with a strong recurring revenue base and low historical churn that has a large addressable market. We believe that our expertise and experience in this sector allow us to move quickly and provide certainty to borrowers amidst strong competition in the direct lending space.

On the repayments side, there were $144.4 million of paydowns across 5 full and 3 partial investment realizations. 2 of our realizations were upstream E&P companies in the energy sector, Verdad Resources and MD America, which made up 26% of payoff activity during the quarter.

We'll briefly highlight these 2 investments as an example of our capabilities in the Sixth Street platform. Our investment in Verdad was in the form of a $225 million term loan facility that we sole-led and agented -- sourced by our energy team and reflects our opportunistic investment approach, providing first-lien reserve-based loans to upstream companies that provide a strong risk/return profile.

Since our investment in 2019, the company's credit profile improved materially due to the attractive development returns in an improved commodity price environment, ultimately allowing the company to refinance through the bank market at a lower cost of capital.

As a refresher on MD America, we made an initial investment led by our energy team in November of 2018, where we closed on a $200 million first-lien term loan, of which Sixth Street platform [held] 40% of the deal. Since our initial investment, there's been a series of amendments ultimately resulting in the company filing for Chapter 11 in October of 2020.

Our asset management capabilities, along with our flexible capital base, allowed us to be a value-added partner, resulting in a successful emergence from bankruptcy in December of 2020, with the lenders receiving 100% of the post-reorg equity.

During Q1, we completed the sale of MD America to WildFire Energy, representing a full exit for Sixth Street's 40% ownership interest in the company. At the time of our investment in 2018, we underwrote to a 12.8% IRR and a 1.30x MOM and ultimately generated a 24% IRR and 1.82x MOM, further demonstrating our ability to create value for our shareholders in complex situations. After these 2 repayments, our energy exposure decreased to 1.7% of the portfolio at fair value.

One other notable exit for the quarter was our investment in Designer Brands, which was one of our ABL retail portfolio companies. We made our initial investment in Designer Brands back in August of 2020, when the retail sector was suffering from the shutdowns brought on by the global pandemic.

Because of our strong balance sheet positioning, we were able to play offense during this time by providing capital to borrowers in need of -- in several COVID-impacted industries. During the quarter, the company repaid the outstanding balance of its term loan credit facility, and we received a 3% prepayment premium on the outstanding balance. Since inception, and inclusive of this quarter's Designer Brands exit, we generated an average gross unlevered IRR of 20.1% across our fully realized ABL investments.

On activity levels generally, we saw a pickup beginning in March, and we are optimistic about our originations and funding pipelines heading into the rest of 2022. The direct lending landscape remains competitive, but we continue to pick our spots and remain selective in our opportunity set, which is expanding alongside the growth of the Sixth Street platform.

As demonstrated by the returns generated during this quarter from our E&P and retail ABL names, we will look to opportunistically deploy capital in areas where our platform and ability to underwrite and navigate complexity allows us to create excess returns across our portfolio.

From a portfolio yield perspective, funding and repayment activity this quarter had a slight positive impact to our weighted average yield on debt and income, producing securities at amortized cost. Yields were up slightly to 10.3% from 10.2% quarter-over-quarter and are up about 17 basis points from a year ago. The weighted average yield at amortized cost on new investments, including upsides in this quarter, was 10.6% compared to a yield of 9.8% on exited investments.

Moving on to the portfolio composition and credit stats. Across our core borrowers for whom these metrics are relevant, we continue to have a conservative weighted average attach and detach points on our loans of 0.8x and 4.5x, respectively, and our weighted average interest coverage remained relatively stable at 2.9x. As of Q1 2022, the weighted average revenue and EBITDA of our core portfolio of companies was $117 million and $31 million, respectively.

Finally, the performance rating on our portfolio continues to be strong, with a weighted average rating at 1.13 on a scale of 1 to 5, with 1 being the strongest. We continue to have minimal nonaccruals at less than 0.01% of the portfolio at fair value, with no changes from the prior quarter.

With that, I would like to turn it over to Ian to cover our financial performance in more detail.

Thank you, Bo. For Q1, we generated adjusted net investment income per share of $0.49 and adjusted net income per share of $0.56. At quarter end, total investments were $2.5 billion, down slightly from the prior quarter as a result of net repayment activities. Total principal debt outstanding at quarter end was $1.2 billion and net assets were $1.3 billion or $16.88 per share prior to the impact of the supplemental dividend that was declared yesterday.

Our average debt-to-equity ratio decreased slightly quarter-over-quarter from 0.99x to 0.95x, and our debt-to-equity ratio at March 31 was 0.91x. We continue to have ample liquidity, with $1.2 billion of unfunded revolver capacity at quarter end against $147 million of unfunded portfolio company commitments eligible to be drawn.

Post quarter end, we further enhanced our liquidity and debt maturity profile by closing an amendment to our revolving credit facility. With the ongoing support of our lending partners, we increased the commitments under the facility, from $1.51 billion to $1.585 billion, through an upsize from an existing lender and extended the final maturity on $1.51 billion of these commitments to April 2027.

Pro forma for the revolver extension, our weighted average remaining life of debt funding is 4.1 years compared to a weighted average remaining life of investments funded by debt of only 2.1 years. At quarter end, our funding mix was represented by 76% unsecured debt, in line with the prior quarter.

I would like to take a moment to circle back on Josh's comments related to the upward movement in interest rates. During Q1, 3-month LIBOR increased from 21 basis points to 96 basis points, and the average floor of our debt investments was approximately 1.1%. At the time of our last call, we expected to reach our average floors in May, and this time line accelerated as reference rates have been above our average floor since April.

To quantify the impact on earnings, assuming our balance sheet and spreads remain constant as of quarter end, for every 25 basis points increase in rates above our average floors, we would expect to see approximately 20 basis points of ROE accretion or an incremental $0.03 per share of net income on an annual basis.

We can further illustrate the potential impact by using the forward yield curve, which projects 3-month term, SOFR, to be 2.9% in 1 year from quarter end. Assuming all else equal, as of the quarter ending Q1 '22, an increase in base rates to 2.9% would imply 150 basis points of ROE accretion or an incremental $0.25 per share of net income annually.

Moving on to our presentation materials. Slide 8 contains this quarter's NAV bridge. Walking through the main drivers of NAV growth, we added $0.49 per share from adjusted net investment income against our base dividend of $0.41 per share. There was a $0.24 per share reduction to NAV primarily from the reversal of net unrealized gains on our position in MD America as we booked these gains as realized upon sale.

The negative impact from widening credit spreads on the valuation of our portfolio was $0.05 per share, and there were minor negative impacts related to the mark-to-market on our outstanding swaps that were not designated as hedging instruments, which amounted to $0.04 per share. Finally, there was a $0.42 per share positive impact from other changes, primarily realized gains on investments of $0.18 per share and portfolio company-specific events of $0.22 per share.

Moving on to our operating results detail on Slide 9. Total investment income for the quarter was $67.4 million compared to $78.3 million in the prior quarter. Walking through the components of income, interest and dividend income was $58.8 million, down slightly from the prior quarter driven by net repayment activity during Q1.

Other fees, representing prepayment fees and accelerated amortization of upfront fees from unscheduled paydowns, were lower at $6.9 million compared to $14 million in Q4 given the elevated portfolio activity we experienced in Q4. Other income was $1.8 million compared to $2.6 million in the prior quarter.

Net expenses, excluding the impact of the noncash accrual related to capital gains incentive fees were $29.9 million, down approximately 8% from prior quarter. Despite the upward movement in reference rates, our weighted average interest rate on average debt outstanding remained relatively flat quarter-over-quarter, primarily from the 1 quarter timing lag on the reference rate reset date on our interest rate swaps.

Before passing it over to Josh, I wanted to circle back on our ROE metrics. In Q1, we generated an annualized ROE based on adjusted net investment income of 11.6% and an annualized ROE based on adjusted net income of 13.2%. This compares to our target return on equity of 11% to 11.5% for the year, as articulated during our Q4 earnings call, and we maintain this outlook heading into the rest of 2022.

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

Thank you, Ian. I would like to close our prepared remarks today by encouraging our shareholders of record, for our upcoming annual and special meetings on May 26, to participate in both. Consistent with the past 5 years, we are seeking shareholder approval to issue shares below net asset value, effective for the upcoming 12 months. To be clear, to date, we have never issued shares below net asset value under the prior shareholder authorization granted to us, for each of the past 5 years.

We have no current plan to do so. We merely view the authorization an important tool for value creation and financial flexibility in periods of market volatility.

As evidenced by the last 8-plus years since our initial public offering, our bar for raising equity is high, we've only raised equity when trading above net asset value on a very disciplined basis, so we would only exercise this authorization to issue shares below net asset value at the sufficiently high risk-adjusted return opportunities that would ultimately be accretive to our shareholders through overing our cost of capital and any associated dilution.

If anyone has questions on this topic, please don't hesitate to reach out to us. We have also provided a presentation which will include this analysis in the Investor Resources section of our website.

As a final thought for today's call, we are extremely optimistic about the road ahead. With current market conditions in mind, we believe the value proposition for our business has never been better for both our clients and shareholders. The decline in purchasing power from the impact of inflation only underscored the value proposition of our franchise as a source of alternative early returns for our shareholders, which we believe to be sustainable.

As then for our clients, we're prepared to provide capital with speed and certainty through periods of volatility in public markets. As the credit cycle continues to evolve based on tightening monetary policy implemented by the Fed, we believe our low leverage and significant liquidity profile positively positions us to play offense in the event of a market dislocation. These types of dislocations have been our greatest periods of outperformance in the past. Though we cannot predict what is ahead, we believe we have built a robust business model that performs through the cycle.

In closing, I wanted to call out how refreshing it has been to be back in the office and be able to interact face-to-face with friends and colleagues and clients and stakeholders. I know the ability to collaborate in-person will continue to provide new motivation and ideas as we push further into 2022. We especially look forward to resuming our annual tradition of the Sixth Street [offsite], where we gather our approximately 400-strong team in Austin, Texas. To our stakeholders, thank you for your continued interest in Sixth Street Specialty Lending.

With that, thank you for your time today. Operator, please open up the line for questions.

(Operator Instructions) Our first question comes from Mickey Schleien with Ladenburg.

Josh, I'm sure there's a ton of questions on interest rates, but I'm going to start with one. On Page 13 of the investor presentation, that shows that the weighted average spread on your floating rate investments came down as LIBOR increased, but I suspect that was probably reflecting the lag in the repricing of the assets.

And when I look at the interest rate risk table in the Q, as you had mentioned in your prepared remarks, you would expect your net interest margin to expand with higher rates. But that assumes everything remains equal, which it never does, right? So I would like to ask what's your view on how you think the private lending market will react to higher short-term rates in terms of maintaining spreads.

Yes. So I didn't think -- can you repeat that last part of the question? What was the last part of the question?

The last part of the question is we're looking at a forward LIBOR curve or a SOFR curve that's very steep. So I would like to ask what's your view on how the private lending market will react to higher short-term interest rates in terms of maintaining spreads.

Yes. It's a question on top of mind for us. So first of all, I think one thing to note is that the steepening of these, LIBOR curve or SOFR curve, and they're about the same when you think about credit spread adjustments, has had an extremely positive impact on the business. If you were to look back at September of last year, we would have probably had a $0.09 drag on the investment income line, so not net income line, but investment income line, to get through our LIBOR floors. And we estimate that to be only about $0.02 today.

What tends to happen in our market, and hopefully, people will be thoughtful about this, they tend to find things on an IRR basis and they don't differentiate between spread and risk-free. And so, hey, we were doing something at 10% to 11% IRR and hey, we're still doing it at 10%, 11% IRR, and therefore, they are pricing with a reduced spread, not willing -- not realizing -- or maybe realizing that a lot of it is coming from risk-free.

So I hope the industry reacts differently. I don't -- I think we have some asset sensitivity in our book coming, for sure. How much the industry captures is, I think, a key question. And all things being equal, you want it in spread and real return instead of risk-free of SOFR or LIBOR. But I think that's a key question, and hopefully, the industry will act -- doesn't allow 1-for-1 trade-off between the return and attribution between risk-free and spread.

Yes. I understand. A couple of housekeeping questions. What are your expectations for settling the convertible, which is coming up? And also, what is the level of undistributed taxable income?

Yes, sure. Thanks, Mickey. It's Ian. I'll take that one. On the convert, we had to make an election 6 months prior to maturity. So that was actually on February 1, and we elected to settle the convert primarily in stock. And there's about $100 million principal amount of converts outstanding today.

And that settlement is about -- I think it's basically all in stock. There's a de minimis amount of cash, I think about $2 million, out of that $100 million in principal...

And even slightly accretive to net asset value...

Because those will be issued [above NAV].

And slightly, I would say, slightly could be dilutive on earnings, although the release valve of that is $0.61 of undistributable earnings, so $0.59 of undistributable earnings, plus we expect some growth in undistributable earnings from -- expected with valuations above the current marks.

And so I think you have -- obviously, we expect to grow above and keep leverage steadier in our target leverage ratio. If we don't, then you obviously can use special dividends to make sure you're still capital-efficient. And we think we have enough spillover income, plus kind of pipeline of realized gains, that allows us -- to give us that flexibility.

And so maybe you should think of it the same way we addressed some early conversion in Q4 of last year. And then [we can see] -- that's a tool that we felt was an efficient way to achieve those goals.

I understand. What did you say the UTI balance was?

$0.59 per share.

5-9, 5-9?

Yes.

Our next question will come from Kevin Fultz with JMP Securities.

My first question is similar to one of Mickey's questions. Given that the economic outlook has shifted in the past few months, are you seeing less competition in the market from other lenders? Just curious if you're beginning to see a shift to a more lender-friendly environment, either in the form of improved documentation or widening loan spreads.

Hey, Kevin. I don't think we've seen it yet. I think there's a couple of forces kind of in the market. One is typically, private markets react slower to the public markets. The second thing that happens, I think, is that there's a decent amount of capital formation in the private credit market, which I think has somewhat of a muted impact on the pendulum shifting. I think that the kind of the tailwind, so I think those are the 2 headwinds.

The first headwind of the slow-to-react kind of goes away over time. The capital formation is what it is. The tailwind, I think, is that, clearly, given that there is -- the TAM has expanded for private credit, which is the volatility of public markets allow -- I don't know how I want to say this. People want to pay for certainty in the context of the volatility in public markets, which increases the TAM for private markets. And I think with that increased TAM, I think that will be a tailwind maybe to the pendulum shifting.

I would also say, because of the slowdown in M&A earlier this year, we've created a lot of, I would say, supply out there that hasn't been deployed earlier. So that will keep tension in the market, I suppose.

[So maybe, we can have -- thank you very much. Of the states], we haven't seen evidence of widening of spreads or better terms at this point. Though as we've seen, because in my remarks, I noted this, the top of the funnel start to fill up, I think there's going to be opportunities to pick our spots, in particular, as Josh mentioned, in some of those opportunistic non-sponsor activities that we see as companies are looking to shore up their balance sheets and play offense in a different valuation of the market. So...

Yes. But the TAM is really going to expand given volatility in public markets and issuers and sponsors and looking for certainty, which should help the capital formation issue.

Okay. Great. That's all really helpful. And then just one on leverage. Your stated target leverage range is 0.90 to 1 and a quarter. As of quarter end, you're at the low end of that target. Are you still comfortable operating anywhere within that range? Or has your internal target changed a bit in the current environment?

So no. And look, I think given the uncertainty in the world, I don't think we're going to operate at the top end of the range. I think how we think about our business and how we think about leverage is you got a burden that's both a capital and liquidity by unfunded commitments and change of spreads given the mark-to-market piece on the asset side of our balance sheet.

And you also want to have a whole bunch of dry powder to invest in volatile moments, which, quite frankly, led the [seeds] to the outperformance in 2020, 2021. I think the industry had cum. return on equity for '20, '21 of about 10%. And we had cum. return on equity of about 35% or 36% in over those 2 years.

And that was a function of us having enough capital, enough liquidity, to make investments. And given the change in the economic environment, I don't think we're going to operate at the real top end of our leverage given we think there's volatility coming, which means there's probably opportunity coming, which means that the -- our capital has relatively -- our capital liquidity has a relatively high opportunity cost.

Okay. That makes sense, Josh. And I'll leave it there. Congratulations on a really nice quarter.

Our next question will come from Finian O'Shea with Wells Fargo Securities.

Josh or Bo, last quarter, you talked about the opportunity budding in, in growth equity, late-stage growth equity, to provide junior preferred structures. We've heard some of that from your peers as well. Can you talk about how that -- obviously, we didn't see too much this quarter. But logically, we would have hoped to, given those -- a lot of those assets have continued to lag in the market. Is this something that's still around the corner? Or have these types of opportunities faded?

No, I think it's most definitely an opportunity. The question is, is how appropriate it's going to be for -- given the structures and the PIK nature of those opportunities for the Sixth Street Specialty Lending fund.

Across the platform, for example, we were involved in the Kaseya, the Datto, Kaseya transaction. We've been an investor in Kaseya, which we think is an amazing company. We think the CEO is amazing for a long time. And so I think those opportunities are coming. The question is we'll pick the right ones that fit into the balance sheet and how we've positioned Sixth Street Specialty Lending given that we think about our dividend as a liability to the business.

I think during the pandemic, people realized it was a liability to the business because you had to pay to keep your RIC status, you had to pay your dividend in cash, you had some flexibility in stock. But it's really, people should think about their dividend as a cash liability. So the question is [appropriateness in sizing], but I think there will be spots to pick over the next couple of years, and we think that the right growth businesses that have the right, unit economics or return on capital and the right TAM and addressable market, still -- there's still some opportunity there.

Bo, anything to add?

Yes. I agree with all that. I think the opportunity set, though we'll pause for a bit with valuations and the private markets resetting, I think the opportunity set will be there and strong. I agree with everything Josh [has deemed appropriate], that we'll pick our spots, and it's a market that we're quite active in across the platform and been having good brand recognition.

Sure. That's helpful. And then, Josh, on the platform level, we saw a couple of new groups set up this quarter, the "More than Capital" Group, the structured products group. Anything you want to talk about there in terms of direct or ancillary benefits to the BDC platform?

Great. Thanks for the commercial opportunity, my friend. So I'll let Bo get "More than Capital", although generally, "More than Capital", we have a great leader in that business and we think it can be value-added to the portfolio of companies and the value proposition of Sixth Street Specialty Lending only grows.

On structured products, we've hired Mike Dryden, who we've known for a long, long, long time, who ran that business at Credit Suisse. And we most definitely think he will be winning opportunities in that space, that will come to the platform. There's like good assets, bad assets, saying you got to be sensitive to. But we really think there's an opportunity.

And Mike came in as a lateral partner that we've known for a long time and is super talented and has a big brand in that space. And so we think there most definitely will be continuing to build the mosaic and skill set of the organization, we think, only enhances the successful returns for Sixth Street Specialty Lending.

Bo, on "More than Capital"?

Yes. We are very excited to have brought on Jeff Stone, who's a 4-time CEO of technology businesses, to help us build out that effort. This will help our portfolio of companies with a lot of common problems they experience in building and scaling businesses. So super happy to have him on, and I think we'll hear more from that group over the next couple of years.

Our next question will come from Bryce Rowe with Hovde.

I wanted to maybe start just on market activity. Bo, you mentioned some level of pickup in March. Maybe you could speak to is that more kind of seasonality of the business, or the source of the pickup would be -- any color around that would be helpful.

Yes, it's a bit of both. There's always a bit of a seasonal Q1 lag as Q4s are generally quite active from an M&A market. So that was pretty typical. I think what was a little bit unique in this quarter is we did have the valuations reset in the public markets. That's the pause, generally, on buyers and seller activity in the M&A market. So the activity has slowed, as I mentioned in my remarks, and in addition to that, we saw spread widening, so opportunistic refinancings slowed down.

You saw that begin to unthaw in the back half of the quarter and the top of our funnel pipeline really starting to fill with more opportunistic M&A, from public to privates, but also, portfolio of companies and looking to be opportunistic in the valuation environment.

Separately, you saw a pickup in non-sponsor activity as the strongest companies in these periods will look to shore up their balance sheets, both for to invest internally in growth, but also opportunistically in M&A. So between what we have going through the pipeline, what we've already committed to, we're pretty bullish on the opportunity set.

And Bo, you would say that unthawing kind of happened a lot sooner than we would have expected.

Yes, you should take a quarter or 2, it was a [little bit unthawing]...

Especially given the move in tech valuations...

Exactly.

So I think that's -- I mean, you hit it, which is some seasonal, some market volatility, and market volatility tends to flow, both M&A and opportunistic refinancing. And I guess, it looks like it thawed a little bit quicker than typically than I would have thought.

Yes.

And do you guys feel like prepayment -- or repayment activity will slow here with the volatility and with higher rates? Or do you have pretty good line of sight into continued repayment activity, exit activity?

Yes, I would say -- so typically, we're -- unlike mortgages, we're not sensitive to rates on prepayment speed as [more like] spreads, and so -- and idiosyncratic events. I would say that you would expect that there's -- that the sign that we discussed a second ago, that will have some impact in our portfolios or portfolio of companies that were up for sale and now might trade and that didn't trade before.

And so there will be -- maybe there was relatively, [outside of the energy box], given the commodity price environment in Q1, there was very little kind of repayment activity. That was the bulk of the repayment activity. Given the commodity price environment, I would expect it to kind of get back to normalized levels to some extent.

Okay. All right. Maybe one more for me, just on the right side of the balance sheet. And this may be a tough question to answer, but you've got an unsecured note maturity early in '23. Just kind of curious how you're thinking about how you might handle it today if it were today, with spreads having widened and rates having widened for unsecured debt in the BDC space?

Yes. So look, I think our unsecured spreads have less beta than others, especially given the upgrade and given the quality of the franchise we built. The great news is we have about $1.1 billion -- $1.3 billion gross of unfunded commitments available to draw, $1.1 billion to $1.2 billion of total liquidity burden for unfunded commitments. I think that maturity is like $150 million...

$150 million.

$150 million. And so I think we have a lot of optionality and flexibility. If we wanted to do it on our line today, Ian, correct me if I'm wrong, that -- what is that -- what is it on a swap adjusted basis, what is that maturity? So it's probably LIBOR 200 or something like that.

Yes. Yes.

LIBOR 200. If you think about our marginal cost of capital on our revolver, yes, I think it's about LIBOR 150 because you offset down and you use line fee -- the commitment fee. And so if we were to do it on a revolver, we have $1.1 billion, $1.2 billion burden for unfunded commitments, and it would actually be accretive to our cost of capital.

And I think that $150 million, that's with LIBOR, again, 200, 199. And so you may actually pick up 50 basis points interest, saving about $150 million on a net basis, on a marginal basis. If you were to do [the line, we have a total liquidity].

Our next question will come from Melissa Wedel with JPMorgan.

First, following up on your comment, Josh, about expecting repayment activity to [one way] a bit, that it will make sense in the context of what's happening with rates, we also recognize that the repayments that you guys have had over the years have driven a lot of sort of outsized fee income. So I'm curious how you're thinking about sort of that line item and the potential for -- what the trajectory could be on fee income as prepayments normalize.

Yes. Okay, I think I -- it was really hard to hear, but what I think I heard, you can say -- you can correct me if I heard this wrong, I think I heard what do you think about the impact of income on your income statement as prepayments normalize. And I'm thinking was that the question?

Yes. That's it, Josh.

Okay. Great. Look, I think, typically, these -- I'm trying to get you the exact data. This has been a low kind of attribution quarter for us. So historically, on average, we get the exact data between accelerated OID prepayment fees and amendment fees, that typically is, call it, on an annualized basis, $0.47 -- $0.52 per quarter on a per share basis, divided by 4, is [$0.14 in the quarter].

I think this quarter was $0.07, $0.07 to $0.08...

$0.09...

$0.09, so it's -- well, it's definitely lower this quarter. So I think that's historically how we've operated, I think, our worst year. And yes, so I would say you could expect it to be kind of probably, $0.03 to $0.07 more per quarter or something like that given the activity levels, but they are surely lumpy quarter-to-quarter.

Our next question will come from Ryan Lynch with KBW.

The first question I had, if I understand your comments correctly, it sounds like the slowdown in Q1 was partially driven by, I think, seasonality with kind of a very robust second half of 2021, also in combination with, I think, some economic uncertainties about what the rest of 2022 looks like.

And though you kind of said that your pipeline had now been growing, kind of to end Q1 and into '20 -- into Q2, my question is, is it's a little bit confusing just because -- or a little bit surprising, I guess, just because the economic uncertainty seemed as high as they've ever been, with rising inflation, labor issues, decreasing equity valuations, geopolitical things out there. And so I'm just curious of why the pipeline seemed to be building at the same time that the economic uncertainties are also building.

Yes. How do you square [that, value around that square, value of] the question. I think the answer lies in the amount of private equity dry powder out there, to be honest with you, which is most of the activity, a lot of it is private equity-driven. And there's always this [greed-fear] thing, which is sometimes, in that sense, [at best with long-term investors], is when there's volatility. And there is a ton of dry powder in private equity, and you're starting to see them put that to work.

Just to make a great example of this, it's not that within the sixth street specialty lending portfolio, but like you've seen that what I gave you right there, okay, with Datto, which is a publicly traded company and just Kaseya, was a private equity-backed company, [so it's like] ventures. And so you're seeing sponsors in certain industries putting money to work given the uncertainty.

Okay. That has -- because like, obviously, those fears and uncertainties are all well known in the marketplace. Everybody is operating with eyes wide open at this point. So with that, has the quality of deal flow or the quality of companies that are transacting, at least, potentially the transaction in the pipeline, have they improved to be higher-quality companies that are potentially in good positions to weather these headwinds? Have you noticed any change?

Yes. Yes. These are really good questions. Look, I would say, I think [there's one thing]. I think everybody sees the uncertainty. I think people have very divergent views of how the uncertainty is going to play out. Soft landing, not soft-landing. How do you deal with the employment gap? You typically, I think, maybe have never seen a recession if you haven't seen the employment increase by 50 basis points.

I don't -- I can't say worldwide unemployment increases by 50 basis points given the employment gap. By the way, as I said, I don't think there's going to be -- there's nothing, I think, that's going to be soft-landing or not. So I think there's clearly divergent views, but we mostly see the activity around businesses that have stronger business models that are able to push through cost and have high gross margins and have operating leverage and still can grow earnings.

And so I think there's very divergent views, but the quality of the businesses are high. The valuations, I think, people have different views are -- given the environment. I think we are less impacted by that given where we're invested in the capital structure.

Our next question comes from Kenneth Lee with RBC Capital Markets.

Just one on the investment portfolio. It's pretty diversified across industries right now, but wondering if you could just talk a little bit about how you're thinking about portfolio positioning. Any marginal shifts within -- across industries, just given the current backdrop and the near-term outlook?

Yes. I mean it's a good question. I don't think there's any big marginal shifts. Look, I think energy is an interesting space. But we typically don't like to lend into higher commodity price environments. But there's been a lot of capital outflows across the energy sector, both in the private and public sides, given 2 big factors.

One factor is ESG issues or concerns, and the second factor is that, that sector historically has been a terrible allocator of capital, which is you have this correlation which is as the prices are high, people put in more capital, that feels like it's been less -- that feels like it's been muted given energy companies focused on free cash flow versus net asset value growth and ESG concerns.

So I don't -- we've -- our net energy exposure has gone down significantly. I think it's like 1.7% of the book today. I think there's room there, but we'll be very thoughtful about how we do it.

On retail, that's come down as a percentage of our portfolio historically as well. Retail and -- is, I think, today is -- the exact amount is 10.7%. I think it's been high as 20% or something like that. But we've had a backdrop of a strong consumer and strong earnings from retail, and the [world was over kind over retail] and that kind of got flushed or got changed in the pandemic. And so as the consumer softens or discounting comes back in and there's more volatility in retail earnings, I think that might change.

So I think on the margin, but I think it's in the band of historically where our portfolio has been, but if you look at those 2 segments, for sure, we're under-allocated given where we are in the cycle. I expect there will be some reversion to the mean. Bo or Fishy, anything to add?

Great. Very helpful there. One follow-up, if I may. And just from a high level, in terms of the ROE, it looks like you're maintaining your ROE targets despite having 13% ROE in the quarter. I wonder if you could just talk a little bit about how you think about ROE over the near term. What are some of the major puts and takes that can impact the ROE one way or the other?

Yes. I mean when you think about our business from a unit economic business -- a unit economics perspective, the things that impact ROE is yields, leverage, so capital efficiency, which is a function of net payoffs plus how we manage -- or net portfolio growth, negative, positive. And then how do we manage our excess capital. We've historically managed that through a combination of growing our capital base through the DRIP and special dividends and credit losses.

I feel pretty good about where we sit in credit losses. I actually think there is some, depending on how things play out, some upside left in the book on unrealized -- realized gains and exceeds our current marks. And so that will have a positive impact to ROEs. I don't see any growing near-term credit losses. So ultimately, it's a function of yields and capital efficiency, and we've done a pretty good job of managing both.

Our next question will come from [Matt Schaden] with Raymond James.

First question for me on the ABL product. Given your ABL loans, they generally fund working capital, and higher inflation tends to drive up both the cost of inventory and working capital needs. Do you think there's any chance higher inflation might actually drive a higher demand in the market for your ABL-type products?

Yes. I mean the offsetting factor is that the consumer has been in a really good shape. And so when you look at gross margin and EBITDA margin expansion across retail, which we've done, quite frankly, we've been involved in Nieman Marcus across the platform for a long time. The income statements are in really, really good shape given the lack of discounting and given consumers post a pandemic.

And so you're right that there is a -- more working capital need, but income statements, you fund working capital through strength of income statements and free cash flow and then the balance sheet and your operating cash flow, so income statement or financing. And so I think that's the offset, and retail tends to be in really good shape at the moment. That could change on the dime for sure.

Got it. That's helpful. Last one for me, maybe following up with you, Josh. Kind of more high-level, what's your outlook for the year-end 2022 private credit default environment? And how much has that changed versus 5 months ago at the beginning of the year?

I still think it's pretty low. I still -- I think the trickier question is '23 and '24. But if you look at our book, I think it's pretty low. If you think about the recent vintages of deals, those companies have had earnings growth, and they started off with good liquidity. And the private credit has been slightly -- I think tilted the [software impact]. And so it feels like it's pretty low, not that much exposure to cyclicals, but we don't have that much exposure to cyclicals.

So I feel pretty constructive about the fall cycle for '22 for, generally, for general credit, especially in private credit. I don't know if Bo or Fishy, you got anything to add?

I agree.

I think 2024 is a bit, much harder question, but I think -- I would expect pretty low if it's all [rates] across the sector.

I can tell you the industries that are going to be hurt, industries are going to be hurt are where there are -- where the kind of low EBITDA margin businesses, where they're relatively competitive businesses, where they have -- where they have had commodity price inputs that they can't pass along to consumers, those industries are going to be hurt.

So paper packaging, non-specialty chemicals, I think -- and that's calling the bulk of those cycles. But in the industries that have relatively low EBITDA margins and no pricing power and high commodity inputs into their cost structure, I think those are the industries that are -- have a higher chance of being hurt.

And we do have a follow-up from Finian O'Shea with Wells Fargo Securities.

Josh, just thinking a bit more from our dialogue on preferreds. And I appreciate your commentary and logic on avoiding too much PIK. But is there a firm line there you're drawing in the sand? Or is there somewhere on the curve of returns where you would take on these sorts of deals?

And I asked because in today's environment, the outlook could very well be that this type of company turns out to be the provider of a large, structured rescue-type opportunity that you've done really well on in the past, obviously. So yes, the question is, is this the hard line in being anti-PIK? Or is it just not good enough today?

No, I don't think we have a hard line. Just -- we are -- as Mike Fishman [would probably say], we are -- when you look at our overall balance sheet, we got tons of liquidity. So we like to think about funding our dividend from operating earnings, so we got tons of liquidity. I think it's a combination of we're bottoms-up investors were -- so it's finding the right opportunities that fit right into our balance sheet.

I don't see us being a large provider of rescue financing in a junior capital position. Our strategy has historically has been providing investment financing of the capital structure where we're not the fulcrum and we're not taking process risk.

So I think if you see us doing some of that type of investing, it's in companies we really, really like, with clean capital structures, great prospects, secular-growing and healthy businesses, is the way I would generally characterize our strategy. And then like, look, I think the fundamental question is does the risk/return work, which is, I've said this many, many, many times, you can't eat IRR.

And so in a -- because that's a structure where you make -- where you can get like 11% to 12% of preferred, but it's callable. And so your MoM to work is like 1.2x, but you're detailed on the capital structure and you're going to lose a lot of your capital. Like that doesn't really work, I think.

And so you have to be thoughtful about the probability of returns and returns given at default or being -- not be in the fulcrum. And so I think we're bottomed-up investors and there's no hard line, and -- but we like some of those opportunities, we don't like others.

Thank you. I'm showing no further questions in the queue at this time. I would now like to turn the call back over to management for any closing remarks.

Great. Look, we really appreciate people's time. We're actually on the West Coast today, so this has been slightly painful for me getting up at 4:30 in the morning to get going]. But we really appreciate people's time.

Mother's Day is coming up. I think -- so in our tradition, we hope everybody take the time to spend with their families and appreciate the people in their lives. And Happy Mother's Day to everybody out there who's listening, including our significant others.

So I -- we really love the dialogue. If you make your way to New York or San Francisco, feel free to stop in, and we'll welcome any people back in our office given the environment. Thanks, everybody.

Thanks.

Ladies and gentlemen, this concludes today's conference call. Thank you for your participation. You may now disconnect.