Good morning, and welcome to Sixth Street Specialty Lending Incorporated September 30, 2020 Quarterly Earnings Conference Call. .

Before we begin today's call, I would like to remind our listeners that remarks made during the call may contain forward-looking statements.

Statements other than statements of historical facts made during this call may constitute forward-looking statements and are not guarantees of future performance or results and involve a number of risks and uncertainties. .

Actual results may differ materially from those in the forward-looking statements as a result of a number of factors including those described from time to time in Sixth Street Specialty Lending, Inc. filings with the Securities and Exchange Commission. The company assumes no obligation to update any such forward-looking statements. .

Yesterday, after the market closed, the company issued its earnings press release for the third quarter ended September 30, 2020, and posted a presentation to the Investor Resources section of its website, www.sixthstreetspecialtylending.com. The presentation should be reviewed in conjunction with the company's Form 10-Q filed yesterday with the SEC.

Sixth Street Specialty Lendings, Inc. earnings release is also available on the company's website under the Investor Resources section. .

Unless noted otherwise, all performance figures mentioned in today's prepared remarks are as of and for the third quarter ended September 30, 2020. 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. We recognize that the ongoing pandemic continues to present a very real and unique challenges for everyone and their families. So we're grateful to those who are able to join us today. And thank all our stakeholders, wherever they are, for their continued interest and partnership.

Once again, I'm here today with my partner and our President, Bo Stanley; and our CFO, Ian Simmonds, both of whom we will hear from later on this call. .

After the market closed yesterday, we reported strong third quarter results with net investment income per share of $0.61, over-earning our Q3 base dividend per share of $0.20. Net income per share for the quarter was $1.21. These results correspond to an annualized return on equity on net investment income of 15.1% and net income of 30.1%. .

On a year-to-date basis, we've generated an annualized return on equity on net investment income of 13.5% and net income of 14.7% based on the beginning year pro forma net asset value per share of $16.77, which is adjusted for the impact of our Q4 2019 supplemental dividend of $0.06 per share..

Of note, these annualized year-to-date return on -- ROEs both exceed our average annualized performance since our IPO through the end of 2019, which we think is notable given the difficult operating conditions experienced during the first 3 quarters of 2020.

That said, based on market conditions today, we believe there are tail risks that all BDC portfolios are subject to, including credit risk and earning headwinds from LIBOR, which in our portfolio is offset by our LIBOR floors and the floating rate nature of our liabilities. .

Our strong net investment income this quarter was a function of both robust interest and fee income as well as lower interest expense attributed to the 100% floating rate nature of our liability structure, which Ian will cover in more detail.

This quarter's net income was supported by unrealized gains related to portfolio company-specific events, spread related unrealized gains from the continued tightening of credit risk premiums during Q3 and realized gains from the sale of our AFS equity position at a price that was significantly above our prior quarter's unrealized mark, which Bo will cover later on the call.

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This quarter's operating results contributed to the growth in our net asset value per share, which hit a record high of $16.87 at the end of Q3. This represents approximately a 5% increase from Q2 and a 1% increase from our 2019 year-end pro forma NAV per share of $16.77.

If we were to add back the impact of the $0.50 per share of special dividends that were paid during Q2, we've grown net asset value per share by approximately 4% year-to-date. .

To reflect on this for a moment, in a year we've experienced tremendous market volatility and economic uncertainty, we've actually been able to grow net asset value per share while paying our highest level of dividends for the first 3 quarters of the year.

This reinforces our belief that we've created a differentiated business model that not only survives, but has the ability to outperform during periods of uncertainty. .

Notable drivers of net asset value growth year-to-date include $0.47 of over-earning against our base dividend, $0.23 of unrealized gains from the impact of effective LIBOR force of 1.1% across our portfolio versus 36 basis points for the broadly syndicated loan market, $0.12 of net mark-to-market gains on our interest rate swaps, primarily related to our 2022 and 2023 notes and $0.11 of net realized gains on investments.

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In the short periods of volatility across Q2 and across Q3, we deployed approximately $150 million of capital across a combination of secondary investments and opportunistic financings. Through quarter end, these investments have generated $24.4 million of P&L, of which $9.7 million has been recognized in investment income..

Though -- therefore, post fees, we've generated to date $22.7 million of value or $0.34 per share solely through investments we made during the period of volatility earlier this year.

Based on a net asset value rebound and the over-earning of our base dividend this quarter, our Board declared a supplemental dividend in accordance with our formulaic dividend approach. .

A supplemental dividend of $0.10 per share, which is half of the quarter's over-earning was declared yesterday to shareholders of record as of November 30, payable on December 31. Our Board has also declared a fourth quarter base dividend per share of $0.41 to shareholders of record as of December 15, payable on January 15.

Adjusted for the impact of the supplemental dividend related to this quarter's earnings, Q3 pro forma net asset value per share was $16.77..

Now let me shift over to a brief update on our portfolio. The latest performance data continues to support our confidence in the overall health of our borrowers.

While none of our portfolio companies have been immune to the economic impact of COVID, only 11% of our portfolio by fair value at quarter end has experienced meaningful performance issues directly related to it. .

We believe the relative resilience of our portfolio is mostly a result of the deliberate shift we made in late 2014 towards a more defensive portfolio construction.

Today, 95% of our portfolio by fair value is first lien, and nearly 75% of our portfolio by fair value is comprised of mission-critical software businesses with sticky, predictable revenue characteristics. .

These businesses also tend to have variable cost structures that can be flexed down to support debt service and protect liquidity in cases of challenging operating environments.

The general nature of our portfolio, along with his first lien orientation, shorter weighted average life and above-market LIBOR floors contribute to a lower beta characteristics to the benefit of our shareholders in times of market volatility. .

At quarter end, our debt portfolio had a weighted average fair value mark of $99, up 3 percentage points from its recent trough at the end of Q1, but below pre-COVID levels of approximately par at the beginning of the year.

Meanwhile, the leveraged loan index at quarter end had a weighted average bid price of approximately $95, up 11 percentage points from the end of March and also below its pre COVID levels of approximately $97 at the end of the year.

As we've previously pointed out, the lower beta of our portfolio is due to a shorter weighted average life and higher LIBOR floors compared to the leveraged loan market. .

Note that the weighted average bid price for LCD first lien software names like our portfolio also experienced less volatility than the broader loan index during this period.

While portfolio has held up relatively well over the past couple of quarters, we'd like to reiterate that credit tail risk do exist in our portfolio and more so today than pre COVID..

At quarter end, 12% of our portfolio had a fair value mark of less than $98 compared to only 8% of the portfolio in Q4 2019. The weighted average fair value mark for names in this tail at the quarter end was $88 compared to $96 at Q4 2019.

Revisiting the concept of anti fragility, the headwinds in our portfolio from credit year-to-date have been more than offset by the tailwinds from the value we've been able to create during the periods of market volatility across Q2 and Q3. .

There was a slight increase in our non-accruals this quarter from 40 basis points to 90 basis points on a fair value basis. This was primarily driven by the addition of first lien loan in MD America, an upstream E&P company, which is partially offset by removal of our pre-petition Neiman Marcus term loan and a partial roll-up of our J.C.

Penney's pre-petition first lien term loan into the DIP term loan..

On MD America, we received a roughly scheduled cash -- a regularly scheduled cash interest payment during this -- during the quarter but applied those proceeds to the amortized cost of our position, given our view of an imminent reorg of the company's capital structure that result in a reduction of the value of our loan. .

Post quarter end, the company made a voluntary paydown of $1.4 million on our position and subsequently filed for protection under Chapter 11 that implements prepackaged plan of reorganization.

For Q4, we expect to put $9 million of our loan or approximately 70% of our remaining prepetition loan and 09/30 fair value, back on accrual status upon the company's emergence from Chapter 11. Our remaining investment will be restructured into an equity position.

Note that in quarter end, our total energy exposure was 2.4% of the portfolio at fair value..

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

Thanks, Josh. During the third quarter, conditions continued to stabilize in the leverage loan market as unprecedented levels of fiscal and monetary stimulus supported ongoing investor demand for risk assets.

Secondary loan prices continue to recover in Q3 and primary issuance activity slowly reemerged in connection with opportunistic financing and M&A. .

On an absolute basis, however, our leveraged loan activity in Q3 remained muted compared to historical levels, resulting in a 10-year low for year-to-date new issuance volumes. These trends carried across the middle markets where overall activity remained modest.

However, we noticed a notable increase in sponsor activity later in the quarter and into Q4. .

In contrast to the muted issuance activity in the loan markets, we had record Q3 originations activity with our highest level of commitment since inception at $436 million and our second highest level of fundings at $332 million. This activity was across 12 new and 4 existing portfolio companies. .

As alluded to in our last earnings call, despite the lack of middle market sponsor M&A since March, we had a very strong pipeline headed into Q3 given our diverse sourcing channels and deep sector relationships as part of our thematic investment approach. .

At a high level, this quarter's new investments were predominantly non sponsored transactions were underwriting and sector capabilities along with significant dry powder across the Sixth Street platform allowed us to be value-add partners for companies and their management teams. .

Examples of this include the $500 million term loan facility that we underwrote with our affiliated funds for the publicly traded biopharmaceutical company, Biohaven.

Similar to our prior investments in Nektar and Ironwood, our Biohaven facility is secured by all assets of the company, including royalty streams from an FDA-approved drug and therefore faces no underlying regulatory approval risk. .

In addition, certain delayed draw portions of our commitments are only available subject to the company meeting key revenue milestones. We've had historical success with our investments in the underlying theme and believe Biohaven continues to exemplify the strength and expertise of Sixth Street's health care franchise. .

Other new investments we originated this quarter include $175 million ABL term loan for Designer Brands, of which we hold $50 million and $125 million accounts receivable securitization facility for Centric Brands, both of which continue to exemplify our differentiated capabilities as solution providers in the consumer and retail sector.

Post quarter end, we fully exited our investment in Centric Brands in connection with a new financing obtained by the company as it emerged from bankruptcy. .

As Josh alluded to in his opening remarks, during our 3-month hold period, we generated a P&L of $3.8 million on our investment, representing a gross unlevered IRR of 31% on our capital invested.

Other ways we created value during the short burst of volatility across Q2 and Q3 were through small opportunistic secondary market purchases in sectors or names that we know well. .

For example, we purchased $50 million par value of Tech Data syndicated FILO term loan at $92 in July and completed the sale of our entire position post quarter end at a weighted average price of $98.4.

Vertafore's first lien term loan was another liquid security that we purchased in late March at a price of $78.25 and sold during Q3 at a price of $99.8. .

Finally, the combination of our small BBB and BB rated CLO purchases throughout Q2 and Q3 have to date resulted in nearly $0.5 million of P&L for our portfolio.

Though not one of our primary investment themes, these opportunistic secondary market purchases continue to be an efficient way for us to enhance the return profile of our portfolio when the market environment permits. .

our $72 million Neiman ABL FILO upon the company's reemergence from bankruptcy; our $51 million Dye & Durham first lien loan in connection with the company's IPO; and our $45 million AFS first lien loan and equity positions in connection with the sale of the company to a strategic buyer. .

Some of you may recognize AFS as one of our longest standing portfolio companies, with our first investment dating back to 2011. Since the original investment, we supported the company through various transitions and ownership changes, including the sale of our majority equity ownership stake to the sponsor in 2018. .

We believe AFS is an example of our asset management capabilities, along with our flexible capital base allow us to be long-term value added partners for management teams and sponsors.

For our shareholders, our equity position in AFS was fully realized this quarter at a value of $16.2 million compared to our prior quarter's fair value mark of $7.3 million..

Moving now to portfolio yields. The weighted average total yield on our debt and income-producing securities at amortized cost increased by approximately 20 basis points to 10.2% this quarter, primarily driven by the favorable impact of this quarter's funding activity.

The yielded amortized cost of new investments in Q3 was 11.5% compared to 10.8% for exited investments. .

Note that LIBOR movement during Q3 had minimal impact on this quarter's portfolio yield given that LIBOR had already fallen below the effective average LIBOR floor across our portfolio in the prior quarter. .

Now a brief update on our portfolio composition and credit stats. Our top 2 industry exposures continue to be stable led by business services at 22.9% of portfolio at fair value, followed by financial services at 16%. Retail and consumer products was our third highest industry exposure increasing from 11.3% to 13.9% quarter-over-quarter.

This was primarily driven by new fundings for Designer Brands and Centric Brands, which was partially offset by the repayment of the Neiman ABL FILO term loan.

Pro forma the paydown of Centric Brands, our retail and consumer exposure would have been 10.5% at quarter end and retail names -- with retail names comprising 9.5% of the portfolio and 77% of this exposure consisting of ABL investments..

In September, upon the full repayment of the Neiman ABL FILO and DIP loans, we subsequently funded a new $17 million par value first lien loan related to our exit financing backstop commitment.

In our schedule of investments, a roughly $4 million difference between the par value and the cost basis of the new Neiman loan reflects our fees on the backstop, which were payable in common stock of the reworked company. .

Our loan today is trading at a price of approximately $104.75. This, again, was another way that we created value during the volatile market environment earlier this year.

We believe our attractive cost base, along with the company's high-quality assets and improved prospective cash flow profile post restructuring provide considerable downside protection on our investments..

As Josh discussed earlier, the overall performance of our portfolio continues to remain relatively resilient, which is a testament to our team's deep knowledge of the industries where we are active and our close relationships with our portfolio company and management teams.

Our portfolio weighted average performance rating was 1.21 compared to 1.23 in Q2 on a scale of 1 to 5 with 1 being the strongest. There were no material changes in the overall credit metrics of our portfolio of companies. .

Interest coverage this quarter remained flat at 3.3x. Net attachment point was unchanged at 0.4x and net leverage increased slightly from 4.3x to 4.4x, which is on par with our trailing 2-year historical quarterly average.

The weighted average annual revenue and EBITDA of our core portfolio companies increased slightly this quarter to $117 million and $36 million given our migration towards larger borrowers as well as organic growth of certain existing borrowers. .

While the path of this economic recovery remains highly uncertain, based on our close engagement with our borrowers, we don't expect any material deteriorations in the overall performance of our portfolio in the near term..

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

Thank you, Bo. I'll begin with an overview of our balance sheet. Total investments at fair value increased by $118 million quarter-over-quarter to $2.1 billion, primarily driven by this quarter's net funding activity and the net unrealized gains on our investments. .

Total principal amount of debt outstanding was $932 million, and net assets were $1.14 billion or $16.87 per share. Our debt-to-equity ratio at quarter end was stable at 0.81x due to the combination of the delevering impact from this quarter's increase in net asset value, offset by net portfolio fundings.

Our average debt-to-equity ratio increased from 0.87x to 0.93x quarter-over-quarter due to the timing of our Q3 repayments, which were mostly weighted towards quarter end. .

On capital and liquidity, we continue to be strongly positioned, ready to capitalize on potential market dislocations. As Josh discussed, our capital and liquidity position has aided our ability to capture value for our stakeholders during these volatile times. .

Our financial leverage of 0.81x remains well below the regulatory limit of 2x, and we had ample liquidity at quarter end with $1.02 billion of undrawn revolver commitments. For context, our current liquidity represents nearly 50% of our total assets.

And we had 12.4x coverage on our $83 million of unfunded commitments available to be drawn by our borrowers based on contractual requirements in the underlying loan agreements. This compares to a peer median using June 30 data of approximately 21% liquidity as a percent of total assets and only 4.4x coverage on unfunded commitments. .

At quarter end, our funding mix was comprised of 69% unsecured and 31% secured debt, and our nearest maturity was approximately 2 years away at only $143 million principal amount.

We continue to be match funded with a weighted average remaining life of our investments funded with debt of 2 years compared to a weighted average remaining maturity of 4 years on our liabilities and revolver commitments..

Turning to our presentation materials. Slide 8 is the NAV bridge for the quarter. As Josh mentioned, the over-earning of our base dividend continued to be an important driver of our NAV growth, contributing a positive $0.20 per share to this quarter's results. .

There was a $0.07 per share reduction to NAV as we reversed net unrealized gains on investment realizations and recognized these gains into this quarter's net investment income, where applicable.

We also benefited from a positive $0.22 per share impact from unrealized gains related to credit spread movements on the valuation of our portfolio and other changes added a further $0.46 per share to this quarter's NAV..

Breaking this last component down, the leading contributors were $0.17 per share of realized gains on our AFS equity position, $0.08 per share of unrealized gains on our Vertellus equity position and $0.07 per share of unrealized gains on our new Neiman Marcus position..

Moving to the income statement on Slide 10. Total investment income increased to $71.3 million compared to $70.2 million in the prior quarter. This was primarily driven by an increase of $4.4 million in interest and dividend income due to an increase in the average size of our portfolio. .

Other fees, which consist of prepayment fees and accelerated amortization of upfront fees from unscheduled paydowns, continued to be relatively strong at $9.3 million, led by our fees related to Dye & Durham and our Neiman ABL FILO.

Other income increased from $6.5 million to $8.1 million quarter-over-quarter, primarily due to the receipt of a onetime termination fee for a commitment we made in Q1 of 2019, but was never eligible to be funded given the required milestones in the underlying loan agreement we're not satisfied..

Net expenses this quarter decreased by $1.6 million to $28.2 million primarily driven by lower interest expense from a lower effective LIBOR on our entirely floating rate liability structure. This quarter, our weighted average cost of debt decreased by a notable 90 basis points.

This was primarily a function of movement in LIBOR during Q2, which flowed through our cost of debt in Q3 due to the 1 quarter timing lag on the LIBOR reset date on our interest rate swaps. .

As a reminder, given our view that our competitive advantage resides in underwriting and managing credit risk, not the interest rate risk, we have a long-standing practice of matching our liabilities with the predominantly floating rate nature of our assets, which are protected on the downside through our LIBOR floors.

We do this by implementing fixed to floating interest rate swaps on our fixed rate debt. .

While our hedging policy means that we forego some earnings upside in higher interest rate environments, it provides us with valuable earnings and capital support in lower interest rate environments, which is when we may need it the most, given their correlation with recessionary periods..

In falling rate environments, like we've experienced year-to-date, we benefit from net interest margin expansion given a decrease in the cost of our floating rate liabilities, while the earnings power of our contractual floating rate assets is protected by the LIBOR floors that we structured into our loan agreements. .

The combination of these 2 forces has been the primary driver of the 100 basis points of net interest margin expansion we've experienced year-to-date, equating to incremental earnings of approximately $2.4 million or $0.04 per share..

Looking ahead to Q4, based on our current asset level yields and assuming an average leverage in line with Q3, we would expect further net interest margin expansion of approximately 10 basis points, based on this quarter's movement in LIBOR. .

On the capital side, year-to-date, we benefited from unrealized mark-to-market gains on our interest rate swaps given the downward movements in the shape of the forward LIBOR curve. At quarter end, we had $31.3 million of cumulative unrealized gains with $13.3 million or $0.20 per share embedded in our 09/30 NAV.

The remainder is reflected in the carrying value of our 2024 notes due to our application of hedge accounting on those swaps. .

As we've seen, the inverse relationship between movements in the forward curve and the mark-to-market on our swaps creates valuable incremental capital cushion for our business in periods of high volatility.

We'd like to note that as we approach the maturity of our 2022 and 2023 notes, and therefore, the maturity of our respective swap instruments, any cumulative swap related unrealized gains or losses will unwind from NAV as we recognize their offsetting impact through interest expense. .

For example, holding the forward LIBOR curve constant as of 09/30, we would expect to see an unwind of $0.09 per year to our NAV per share over the remaining weighted average duration of 2.1 years on our 2024 -- 2022 and 2023 notes as we simultaneously benefit from lower interest expense in our net investment income..

With that, let me wrap up with a word on our full year guidance. Year-to-date, we've generated an ROE on net investment income of 13.5% based on year-end 2019 pro forma NAV per share of $16.77. This puts us ahead of our NII guidance, which was based on an ROE target of 11% to 12%.

Given the performance of our portfolio to date and our visibility into the strength of our investment pipeline, we are revising our full year 2020 NII per share guidance to be in excess of $2.11..

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

Thank you, Ian. It goes without saying that nobody could have predicted the operating environment we faced for the first 3 quarters of 2020, but we're proud of what our business and our people have been able to accomplish.

In the midst of a pandemic, with the majority of our team continuing to work remotely, we've generated record originations activity and are on track to deliver one of the strongest full year ROEs for our shareholders. .

In our view, none of this would have been possible without understanding of the unique constraints and challenges of the BDC model and the measures we've implemented on both sides of our balance sheet to help our business drive in periods of uncertainty. .

That said, we continue to evolve our thinking based on our assessment of underlying risks, trends and developments in the world around us.

This includes an ongoing assessment of our liquidity and funding profile as well as an evolution of investment themes into new sectors or strategies we believe our human capital can be applied to generate value for both of our shareholders and our clients. .

As a business, it's hard not to be reflective given that we founded Sixth Street during the financial crisis 11 years ago. And today, we're faced with an ongoing pandemic.

In our view, these 2 regressive events have shed light on the fact that we still haven't confronted the history and legacy of institutional racism, and we've continued to live with the consequences of our failure to deal with massive wealth inequality. .

We firmly believe that the adversity in our people, in our society today can create tremendous opportunities for improvement, not just lead to dark places.

Looking ahead, our hope is that we all, in whatever ways we can, focus on healing conversations, equity and in our roles as market actors insist that we preserve the power of capitalism, which we firmly believe creates the best outcomes for society, albeit in a better modified way. .

We will leave you with one of our favorite thoughts from the Reverend Dr. Martin Luther King, Jr. "The arc of the moral universe is long, but it bends towards justice.".

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

[Operator Instructions] our first question is from Rick Shane with JPMorgan. .

I wanted to start by just looking at the pending maturities within the portfolio. When we look at 2020, you have one sort of normal way transaction that's maturing, which is Quantros, it's carried a little bit below fair value -- or excuse me, a little bit below cost. I'm curious what the path there is.

And then as we look into 2021, you've got 3 significant maturities, MedeAnalytics, IRGSE and then 99 Cent Stores (sic) [ 99 Cents Only Stores ]. Those are all carried slightly above cost. I suspect 99 Cents is doing very well. If you could just give us a little insight on the other 3 investments, that would be helpful. .

Sure. Rick, good morning. So Quantros is actually in the sales process. It's sold -- Bo, correct me if I'm wrong. It's sold about -- we had a significant pay down. It sold some assets, software and analytics business, sold some assets maybe 1.5 years ago, 2 years ago. They're in the process of selling the rest of the business.

But I expect that to be cleared up. IRG is a controlled portfolio company. 99 Cents is doing well. And there's going to be significant refi risk.

And what was the other one there?.

The other one was MedeAnalytics and that has paid off. That business was sold and has since paid off. .

Great. Okay. And then that's very helpful because obviously, everybody is sort of asking about maturity default. So that clears that. .

Rick, just let me -- I want to clarify because I think you're talking -- your focus on like this tail concept of tail risk in existing portfolios.

And I want to clarify one of the things we talked about in our earnings call because the information, the names that we shared earlier included new names in each of the respective periods that the market were less than $98, which had a -- which could have had an impact from OID. .

So if we booked a new name, it's going to be at OID. The market is going to be less OID. It was included in tail names, even though that probably -- it's not really a tail name. If you exclude the new names that are obviously not tail risk names at quarter end, 8% of our portfolio had a fair market value of less than $98 compared to 4% at Q4 of 2019.

The average price of those tail names in Q4 was $95 compared to $85 in this quarter. .

Got it. Okay. That's helpful. You're right. I was thinking a little bit about tail risk. The other investment I'd like to just talk about is Biohaven, which I think is a sort of a different investment for you. If we look, that's a company that is consistently losing money, seems to be burning cash. I realize your portion that facility is relatively small.

But just like to talk a little bit about what's driving what appears to be a different type of investment in that particular company?.

It's actually not -- it's the same exact investments that we had in Ironwood and Nektar. So those were large biotech companies who had an in-place IP and drugs that had sales, and then they were investing in R&D to expand the portfolio.

And so if you look at the exist -- if you had looked -- if you kind of parse out the business and said, their existing drug portfolio that has revenues that has in-place IP and you look at that and you looked at the DCF of the value of that in-place IP, it significantly covers our loan.

And so it's exactly the same theme as Ironwood and Nektar, who both paid off and were good investments for us. .

So the -- there's kind of a couple of different types of bio businesses, one biotech business, one set of biotech businesses that have no in-place revenues, no cash flows, all kind of on the come, those don't have a credit story. Then there are biotech companies who have a drugs or portfolio of drugs, but they're massively reinvesting in new drugs.

And when you parse out, there is an underlying credit story either based on royalties or the value of IP from in-place drugs that are providing revenue. And so Biohaven actually has the market-leading migraine drug or 1 of the market-leading migraine drugs. .

Got it. I think, in the current environment, exposure to migraine relief is probably a good place to be. Thanks for the context. .

I mean I think Ironwood was like IBS and constipation medication or so -- or I think the Ironwood. So that could have been applicable, too. .

Our next question comes from Devin Ryan with JMP Securities. .

Maybe start here with a bigger picture question since it's on top of everyone's mind. I'd love to maybe just get a little perspective around how you guys are thinking about a scenario to the extent we do have a Biden White House, but a Red Senate, so we probably don't see tax legislation change, probably less stimulus.

And related to that, you mentioned the pickup in deal flow over the past couple of months. I think that's consistent with the broader M&A markets.

But if credit and equity markets remain reasonable in either, call it, political outcome that could happen here, do you see anything that could change kind of the strong momentum in new deal flow?.

No. Look, I think you're right, which is -- I'm not -- by the way, I'm not -- I think both sides want to get some type of stimulus done, which I think is net positive for markets, including credit markets. I do think significant undoing of the Trump tax reform is probably off the table or specific stimulus into Blue States it's probably off the table.

We saw that, obviously, in some of the New York [Technical Difficulty] stocks yesterday that were significantly down..

The -- but on the corporate credit side, keeping corporate tax rates as is, is probably positive for credit and positive for valuations.

And so I think putting personal politics aside, the markets like, I think, like the outcome of or at least yesterday and today on premarket, like the outcome of stability in knowing what the rules are, stability on knowing what corporate tax rates are and my guess is that there will be some type of stimulus both sides of table. .

Okay. Terrific. And maybe just a follow-up here. So PIK income is obviously somewhere we've been focused in your PIK income as a percentage of total investment income is very low at 3.2%.

And so I'm just curious, if that's just a function of some of the portfolio positioning that you've spoken about, just the health of the portfolio? Or is there something else going on there as we think about moving forward?.

Yes. So I think, first of all, PIK income, I think on a notional basis, Ian, correct me if I'm wrong, was only up like $100,000 quarter-over-quarter. .

That's right, Josh. .

And that was a function of, I think, 2 new names in that PIK component, Biohaven and Forescout and a full quarter of PIK income on service channel Sprinklr with relatively small positions. And those were not -- none of that was related to restructuring. So those were related to investment choices we made. .

The activity level on amendments were significantly down quarter-over-quarter. And so -- and I don't think there was any amendments the last quarter that had put -- that had -- where we added PIK income.

And so I think that's a function of where we position the portfolio pre-COVID, where in the capital structure and, quite frankly, on a sector basis, I think as we mentioned in our earnings script, really, we report our industry exposure by end markets served. .

But really, when you look at our portfolio, I think 75% of our portfolio is tech-enabled business service-as-a-software, which have very significant revenues and decently variable cost structure. And so people have been able to kind of live through the volatility given the nature of the structure of the businesses that we chose to finance. .

Our next question is from Robert Dodd with Raymond James. .

Josh, during -- I think this is actually Bo, you mentioned notable increase in sponsor activity at the end of Q3 and Q4, I mean, that's consistent with what we've been hearing.

But at the same time, I mean, obviously, Biohaven, Designer Brands, Centric, those are the more niche asset by really good credit security, very high IRRs, which we can obviously see with Centric Brands, this has already been realized.

What will -- the sponsor type business tends to be a lower IRR, maybe longer-lived asset, but then the ABL stuff, higher IRR shorter lived asset. .

Looking forward, tough question, what do you -- what areas do you expect to see and I'm not just talking about Q4, talking about 2021, et cetera, do you expect to see the most capital deployed into? Is the market shifting right now from what was more ABL during the tougher periods to maybe more sponsored in '21? Or can you give us any thoughts on that?.

Yes. So it's a great, great question. I'm not sure I'm going to have a greatest answer.

How we've set up our business model is really to focus on multiple channels and in investments in industries that we like the -- in investments perhaps in industries that we like that we think have good credit characteristics, i.e., that the -- because you don't -- even in the sponsor business, even when they might be longer weighted average life, you don't really own a right tail.

Like you don't -- you're not going to make 4 or 5x your money. And so you got to figure out, you got to spend your time and truncate the left tail. .

And so that's -- when we think about our business, we think about looking for and prospecting for a deal that has a return profile that doesn't have a left tail. And so that's both -- and then we've set up our business where we're kind of agnostic towards channels.

And so we're agnostic towards sponsored channel and nonsponsored channel, stressed rescue financing healthy businesses as long as that distribution is consistent and acceptable and, on occasion, we might take some probability of loss but you got to have -- really have a higher expected MOM. .

And so I don't have a -- I would have thought if you would have said in March or April, where was all of our activity going to be? I would have said, all of our activity is going to be in rescue financings.

And I think that, quite frankly, was offset by a ton of stimulus and the Fed either kind of threatening or actually participating in credit markets. .

And so hopefully, how we have our business set up is we don't have to -- we're not levered to any one channel. And so because if we -- obviously, the world has changed and changes pretty quickly.

On the margin, I think that there are going to be more tail risk industries out there, obviously, real estate is one, we'll probably not do any real estate in the BDC because we do corporate lending, but that's an example one. .

Retail, I think, is -- continues to be in a world of hurt. And we probably can smartly deploy some capital there and continuing to do some asset-based stuff where companies have broken balance sheets through carving out specific assets, either through inventories or receivables. So I think that will continue to be an opportunity.

But I also think that the regular way sponsor finance in our industries that we like will also continue to be an opportunity. .

So I know I didn't answer your question. I guess the answer is we don't know we're set up to cover, works as a platform and a $47 billion asset manager in the credit space, we're kind of set up to capitalize on wherever it comes from. .

Bo or Fishy, do you have anything to add? And by the way, Fishy continues to be an active participant in business, so we make them join these calls.

Bo and Fishy, do you have anything to add?.

No. I mean, listen, you're 100% right, Josh, the thematic approach in omni-channel approach allows us to be active when each of those channels have muted activity like we saw in Q2 and early Q3 in the sponsor M&A transactions.

We saw that activity picked up, the natural arc of gestation periods of deals means that you start seeing that activity really come through in like Q3 in the pipeline in Q4, which we see, that was really pent up, and there's a lot of pent-up demand for M&A given where asset prices are right now. .

So it's a very active environment. I think you're hearing that across the industry.

I would expect, and this would just be a guess that you would continue to see kind of normal levels of M&A going forward without some sort of dislocation, but we're also seeing a lot of opportunities across our other directed company, retail ABL, so the pipeline feels very balanced right now. .

Yes. I'll just add. I mean, I think a lot of what we do are core software business services. We did see a pretty good snapback in the last few months as far as activity goes. And yes, I expect that to carry into next year. So that should continue along with what everybody else mentioned, retail ABL, asset-based restructurings and the like. .

I appreciate that. And I really appreciate that. I basically asked a crystal ball question, but I appreciate the color. Just I kind of follow-up. On the M&A activity and the sponsor activity, I mean can you give us just a quick view on how pricing is? I mean, I presume spread widening largely are back-weighted it seems. But documentation, et cetera.

Can you give us any quick comments there?.

Yes. Like I'll quickly step in there. I think compared to pre-COVID, you're still seeing levels -- leverage levels down modestly, better documentation than you were seeing pre-COVID. From a pricing standpoint, there's probably still a premium to pre-COVID but that is -- it's definitely getting competitive, and that is starting to tighten up. .

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

Just one question on the -- for sort of Joshua, Ian on the LIBOR swaps, that's -- it was interesting color on the reversal coming up and the gains you've had and obviously, was a patient strategy to have had in place going into the recession before that LIBOR was going down but where things are now, as these unsecureds roll off soon, assuming you all replace those soon, would you still execute that same strategy or structure? Would you still swap to LIBOR given it's essentially 0? Any color on that, that would change going forward?.

Yes. Look, look, our belief -- our fundamental belief is that we have the ability to underwrite, manage and pick credit risk and manufacture strong credit risk premium. We don't really have the ability to figure out the macro. And so LIBOR, as you say, LIBOR is closest to the pin to 0..

That being said, there's arguably negative real rates right now. And there's negative nominal rates in Europe. So like don't -- I don't -- you should not think about LIBOR as a -- I would not think about LIBOR as a floor. Now I'm not calling for negative rates. But you shouldn't think as 0 is an absolute floor.

Zero is a number just like negative 30 is a number. .

So I would say we will continue to have -- we'll look at it when we make that call, but we'll continue to have a bias where we think can -- we think we do some things well and have a skill set and we continue -- and we do some things not well or don't have the -- we might do well. We don't think we have the skill set to do well, which is the macro. .

And so that is a little akin to us, would you stop hedging your foreign currency exposure by borrowing in local currency? And so the answer is independent of where you think there's going to be a reversion to mean or independent what you think currency swap rates are, cross-currency swap rates are, we probably wouldn't do so just because we don't have that skill set.

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So I would expect -- we haven't talked about it for a while, but I would expect that our general North Star remains unchanged and I would -- our LIBOR, our swaps just to be clear, unlike our bank deal does not have floors. And so if LIBOR does go negative, our cost of funding is going to go down on our notes, whether it's existing swap.

There's a floor of 0 on our bank revolver, but in our -- there's no 0 floor. .

Ian, do you have anything to add?.

No. I think, Fin, you actually understand the concept anyway because on day 1, when we enter into a swap, the NPV is 0. So then I'll just revert back to the comments that Josh made about where our skill set lies beyond that in terms of forecasting on a macro basis. .

Yes. No, I appreciate it. Actually, one more question popped up. .

If then, the one -- I know you get this one thing just for other people who might be listening, that there's a significant correlation between when rates go down, that there's a kind of economic uncertainty, right? Because as a policy manager, as a policy matter, people are using -- use rates and monetary policy as a form of stimulus. .

And so the -- and right now, we basically have, on our asset side, we have basically a fixed rate of return given our LIBOR floors. And so in environments where there is a ton of uncertainty and policymakers are pushing rates down, we probably have credit losses. .

And so we like the benefit in that environment from the net interest margin experience, which we've massively -- which we've actually massively has helped us by 100 basis points or 110 basis points projected next quarter.

And so what we do give up is we give up in massive risk on environments, and we give up some ROE expansion if we have a whole bunch of fixed rate debt. .

The other thing I would say, the last thing I'll say on the subject is, another theme is like, is that our dividend is -- could be argued, excluding the environment we live in today, which is expecting some credit losses, as safer today than it was a year ago, so because of the net interest margin expansion. And so I think that is one.

We have more net interest margin than we've had historically, which is protect -- which actually provides safety for our dividend and safety for the -- for future credit losses. .

Sure. And on spillover, I know you've paid out the $0.50, and I think, first quarter, your undistributed NII is already above where it was before that.

Are we looking at another -- are we looking at another special, special, as you may call it, or extra?.

Yes. So it's kind of -- I'll let Ian answer the second piece. It's had a little bit of a bummer, right? We did that -- we've tried to avoid doing large specials when we put in the recurring, supplemental dividend framework 2, 2.5 years ago.

And then given that the level was set at only at $0.50, we ended up having friction costs and kind of growing the spillover income and growing, unfortunately, on a per share basis, the excise tax. And so we wanted to clean it out. I think we're basically back pre-clean out.

Is that right, Ian?.

Yes. At the beginning of this year, when we went to the Board with the proposal, we were at $1.61 per share of undistributed income. And at the end of Q3, we're at $1.55. So we're pretty much back there. .

And so as a -- I think we'll look at, Ian, correct me if I'm wrong, the plan is to look at where we sit on a tax basis and look at the 90% rule and look at how much of excise tax is a drag on earnings? And we'll go through the same work we did at the end of the year, at the end of this year. .

Congrats on the quarter. .

Great. Thanks, Fin. Hope you and your family are safe. .

Our last question is from Ryan Lynch with KBW. .

A lot of BDCs have talked about really positioning their portfolio late cycle over the last several years, but not all BDCs' portfolios have really held up as well as yours has so far. And I know there's -- you mentioned there's still a lot of credit risk in your portfolio, and we're still in the midst of a downturn.

But so far, you guys have grown book value meaningfully in 2020 in the midst of this downturn and have had actually one of your best ROE, net income ROE generation years that you guys have had in the midst of this downturn.

So I'm just curious, are you guys surprised how well your portfolio has held up in the midst of this downturn and how much value you guys have been able to create?.

Yes. I wouldn't -- look, hindsight is always 2020. So I think we feel very good about where we are today in the portfolio today. I'm a little bummed that in the midst of -- and again, hindsight is 2020 and I've had these conversations with people a little bummed that we turned off our stock. .

We didn't buy enough bonds back in those moments, a little bummed that we didn't buy back, we turned off our stock buyback program in middle of March to protect liquidity. I'm a little bummed that we created, quite frankly, a whole bunch of value in Q2 and Q3 by being a little bit active. There was probably more opportunity to be had there.

But uncertainty was very high. And so I don't give us a path. Look, 2020 hindsight I'm a little bummed. So I feel very good about what we were able to accomplish and how we protected the balance sheet. .

And -- but that all started with, I think, protecting the balance sheet and it was only a decision of what assets we chose to finance.

It was -- because there were some of our peers who had financed similar assets, but they were -- they got back and then doing unnatural things because they didn't reserve for unfunded commitments, they didn't think about drawdowns and net asset value during times of volatility and what that meant for offense. .

And so I think it's a combination of -- the ROEs this period are a combination of assets we picked to finance and position the left-hand side of the balance sheet, but it's also how we position the right-hand side of the balance sheet to be able to make the business at minimum, robust, but possibly anti fragile, where we were able to attack opportunities during times of volatility, which we've always talked about.

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And so am I a little surprised? Yes. But I think it's what we thought about and how we thought about the business. And quite frankly, I thought a lot of the disciplines we put into our framework ahead of the crisis allowed us to capitalize a little bit in hindsight at which we would have capitalized more..

Ian, Bo or Fishy, anything?.

No, I think that's right. .

Agree. .

Okay. Yes. We're well done. You mentioned in some of your earlier comments, prepared remarks, some of the secondary opportunities that you guys had and the value you created in the second and third quarter.

Looking into the fourth quarter, are there still any opportunities in those markets at all? Or given the kind of run-up in prices, is that kind of market kind of gone away at this point?.

It feels like it's gone away. I mean things are not obvious. So for example, the structured credit market is not as obvious to us. On an opportunistic basis, I think there's still value to be had there. But given that it's kind of not -- I won't say outside the lane, but it's an adjacency.

It's -- there's -- it's not that seeming value that we're going to kind of go out of our lane. .

I would say, I think there's opportunities in regular way direct lending. That we think is interesting. But we are positioning, look, the path of COVID is highly uncertain.

And we are -- I think we are continuing to position our balance sheet to not saying that there's going to be more volatility to come, but if there's more volatility to come, both from how much capital we have and how much liquidity to have to be positioned to lean into that volatility if it does come.

And so I'm -- our balance sheet was I think pretty well in position, pre-COVID, it's actually in better position today given we have more capital. We have -- debt-to-equity is lower. We have basically the same amount of liquidity.

Ian?.

No, I think you captured all of it, Josh. .

Okay. And then I just had one more. I think earlier, you were talking about -- Robert was asking about the kind of terms and structures on sponsored deals. I think you said they were maybe modestly better from leverage levels or documentation and maybe a little bit better on pricing, but maybe that's coming down. .

Just curious your thoughts on even if terms, documents, structures haven't materially improved since where they were maybe pre-COVID, would you still consider a new investment today versus a year or 2 ago, potentially a better risk-adjusted opportunity just because if you're making an investment into a new portfolio of companies, today, you're at such an information advantage versus where you were a year or 2 ago because you'd have this -- recency you have seen how this particular businesses is performing during a very severe downturn.

So while the terms and structures may not have improved significantly, the risk-adjusted return is better because of the information advantage you potentially have?.

Yes. So I think that's a very valid framework and a very valid argument. I think it all comes down to the underlying idiosyncratic credit. And then I don't think that you can underestimate the volatility in both our portfolios and how businesses performed was most definitely muted by the significant stimulus.

And so you kind of got a window but -- into how things performed, which I think most definitely is an informational advantage and which is helpful in your underwriting. .

That being said, you had a whole bunch of stimulus through PPP loans or through just broad-based stimulus that you really -- that tide kind of went out and then kind of got stopped.

If that makes sense? But I think your framework is a valid framework, which is, yes, like you get to see how cost structures behaved, how management behaved, how sticky were the revenues in the backdrop of COVID? And then I would say, plus at the backdrop of stimulus. .

Yes. Yes. So I guess a couple of different factors there, with the government coming in and talking about stimulus. .

And this concludes our Q&A session. I would like to turn the call back to Joshua Easterly for his final remarks. .

Great. We have a little bit of a history of wishing people happy holidays and the Thanksgiving is coming up. And so what I would say to people is, I think one of the silver linings of COVID is, people, for better or worse, got to spend a lot of time with their family. For me, it's been, quite frankly, amazing. .

And so hopefully, people take the time given all the strife in the world and on Thanksgiving and really take the time and appreciate the things they have and figure out how to make the world a better place. Thank you. .

Thank you, ladies and gentlemen. This concludes today's program. You may now disconnect. Have a wonderful day..