Good morning, and welcome to Sixth Street Specialty Lending, Inc.'s Second Quarter ended June 30, 2024, Earnings Conference Call. At this time, all participants are in a listen-only mode. As a reminder, this conference is being recorded on Thursday, August 1, 2024. I'll now turn the call over to Ms. Cami VanHorn, Head of Investor Relations..
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 second quarter ended June 30, 2024, and posted a presentation to the Investor Resources section of our website www.sixthstreetspecialtylending.com. The presentation should be reviewed in conjunction with our Form 10-Q filed yesterday with the SEC.
Sixth Street Specialty Lending, Inc.'s earnings release is also available on our website under the Investor Resources section. Unless noted otherwise, all performance figures mentioned in today's prepared remarks are as of and for the second quarter ended June 30, 2024. As a reminder, this call is being recorded for replay purposes.
I will now turn the call over to Joshua Easterly, Chief Executive Officer of Sixth Street Specialty Lending, Inc..
Thank you, Cami. Good morning, everyone, and thank you for joining us. With us as our President, Bo Stanley; and our CFO, Ian Simmons. For the call today, I will provide highlights of this quarter's results and then pass it over to vote to discuss activity in the portfolio.
Ian will review our financial performance in more detail, and I will conclude with final remarks before opening the call to Q&A.
After the market closed yesterday, we reported second quarter adjusted net investment income of $0.58 per share or an annualized return on equity of 13.5% and adjusted net income of $0.50 per share or an annualized return on equity of 11.6%.
As presented in our financial statements, our Q2 net investment income and net income per share inclusive of the underlying of the non-cash accrued capital gains incentive fee expense were both $0.01 per share higher.
At June 30, our net asset value per share reached a new all-time high at $17.19, representing an increase of 2.7% year-over-year an annualized growth of 3.4% since inception, part the impact of special and supplemental dividends were distributed over that time.
We don't want to sound like a broken record, but our outlook for this sector remains consistent with what we've said in our previous earnings calls. The higher for longer interest rate environment provides support for BDC operating earnings, but the tails within portfolios are growing on the margin.
Our Q2 quarterly results reflected a continuation of these themes. Adjusted net investment income of Q2 exceeded our quarterly base dividend level by 26%. As we assess our projected dividend coverage over the long term, we look at the shape of the forward interest rate curve.
As of today, the forward rate curve bottomed out at a terminal rate of approximately 3.5%. Based on this curve, we believe that our base dividend of $0.46 per share remains well supported by operating earnings in this interest rate environment.
As we have said in our last two earnings calls, we expect to see dispersion between operating and GAAP earnings as a higher base rate interest rate may ultimately lead to credit deterioration potential for credit losses.
We’re starting to see this plan on Q1 results as net income ROEs for our peer set were approximately 140 basis points below operating ROEs. We slightly outperformed these results in Q1. This dispersion highlights the growing sales within portfolios that we've been talking about for several quarters.
Before passing it to Bo, I'd like to take a big step back to emphasize, well, we're in the business of creating value for our shareholders at a minimum, that means earning our cost of equity, but our goal has always been exceed it.
Given the rapid change in the current environment in private credit is one key question that operators should be asking ourselves which is what the required spread on investments to earn that cost of equity. This is a framework that guides us to maintain an investment selectivity and discipline in a competitive market environment.
We are actively passing on deals getting done at spreads that would generate an estimated return that's below the industry’s cost of equity. We acknowledge that pricing floor exists in the BDC and capital should not be allocated to investors being close certain spread.
We'll walk through this in detail now to clearly demonstrate the operating and successful BDC is about disciplined capital allocation. We’ll start with the assumption the average cost of equity for publicly-traded BDCs 9.4%. This is based on the data source from Bloomberg across our peer set, which incorporates continued treasury.
For simplicity, we’ll assume management and incentive fees, leverage cost of funds and operating expenses are based on the LTM average for the sector. While management incentive fee structures as well as leverage vary across the industry, these minor differences do not result in a different conclusion.
Using the current three-year sulfur swap rate of approximately 4%, 1.5% LID, over a three-year average life required portfolio spread to earn a 9.4% cost of equity is approximately 620 basis points from the sulfur.
It is important to note that this outlook reflects leverage at the top end of the range indicated by rating agencies to be designated investment grade and as before the impact of credit losses.
Historically, annual credit losses have averaged approximately 100 basis points to 130 basis points on assets accordingly before drug lending index, including credit losses based on this data, the required spread applying our cost of equity assumption is 750 basis points to 780 basis points.
To explicitly show why we are passing on deals getting done at a spread of 450 basis points and below, the return on equity before credit losses of 6.3% and 3.4% to 4% asset losses. At these spreads the sector is not earning its current dividend yield let alone as cost of equity.
While we acknowledge this must be viewed on a portfolio basis, we outlined the map to be illustrative yet constructive in the path to shareholder value creation. For us specifically, our cost of equity is lower than the factor based on the Bloomberg data and we have had significantly lower credit losses through the long-term industry average.
Taking a look at our portfolio, the weighted average spread of new investments this quarter was 6.6%. If we apply a spread of 660 basis points to our unit economics model including activity-based fees on a three-year profile average leverage at 1.2x and credit losses between zero and 50 basis points. The output is 11% to 12% return on equity.
Again, the math is basically a weighted average of one quarter's new investments which compares to a weighted average spread the portfolio at fair value of 8%.
This clearly indicates that we are continuing to over our cost of equity, our track record of generating a 13.5% annualized ROE and net income since our IPO in 2014 further demonstrates its consistency. Yesterday our Board approved a base quarterly dividend of $0.46 per share to shareholders of record as of September 16th payable on September 30th.
Our Board also declared a supplemental dividend of $0.06 per share related to our Q2 earnings to shareholders of record as of August 30th, payable on September 20th. Our net asset value per share pro forma for the impact of the supplemental dividend that was declared yesterday to 17.13 [ph].
So we estimate that our spillover income per share is approximately $1.15. With that, I'll pass over to Bo to discuss this quarter's activity..
Thanks Josh. I'd like to start by sharing some observations on the broader macro economic environment and how that's impacting deal activity in the private credit markets. Over the last few weeks, US economy has started to show signs of softness evidenced by an increase in unemployment claims in reduced corporate pricing power.
This data suggests there may be room for rate cuts on the horizon, which we anticipate will encourage a rebound in deal activity from a historically low levels experienced over the past two years, while not yet back to the pre-late rate hike levels, green shoots in the deal environment contributed to another busy quarter for our business in terms of deployment and repayment activity.
In Q2 commitments and fundings totaled $231 million and $164 million, respectively across eight new and five existing portfolio companies. We continued to benefit from a size and scale of six used capital base as we participated in several large cap transactions during the quarter.
This underscores the power of the platform as we can toggle between small and large cap opportunities based on where the relative value and risk reward is appropriate for our shareholders. Further, we can maintain a steady deployment pace and further diversify the portfolio through periods of higher competition for lower deal activity.
As a result of our wide originations funnel, we continued to source new investment opportunities this quarter with 83% of total fundings of new portfolio companies. To highlight our largest funding this quarter, we agented and close on a senior secured credit facility to merit software holdings.
This investment is reflective of our core competency in the middle market where our direct relationships position us well to be a solutions provider for companies like Marriott. Through our connectivity across the six replatform, we have multiple touch points with the company from inception of the business too and we executed on the transaction.
Additionally our expertise in niche markets allowed us to move quickly and with certainty to finance this company of best-in-class SMB vertical market software businesses.
On the repayment side, tighter spreads triggered a long-awaited reemergence of payoff activity as borrowers took advantage of the opportunity to lower their cost of financing and address near-term maturities.
We expect $290 million of repayments from six full, four partial and 20 structured credit investment realizations resulting in 127 million of net repayment activity for the quarter.
Our repayment activity was largely driven by refinancings including a takeout by the high yield market, two refis in the private credit markets and one refinancing to a bank loan. We also experienced a payoff in our retail ABL 3, which I'll discuss further in a moment and opportunistically sold 25 million of our structured credit investments.
The majority of our payoffs came from older vintage assets with five of our six full payoffs being 2020 and 2021 investments and the other being from 2017, we had $0.04 per share of activity based fee income from these realizations, representing an increase from last quarter but still below our long-term historical average as older investment realizations contain lower embedded economics compared to newer vintage names.
Following this quarter's repayments, 58% of our portfolio is represented by investments made after the start of the rate hiking cycle.
We believe our exposure to newer vintage assets positively differentiate our portfolio relative to the sector increase the potential for incremental economics through our call protection, accelerated OID and other activity-based fees should repayment activity persist in the second half of the year.
Our two largest payoffs during the quarter, ReliaQuest and Homecare Software solutions were driven by refinancings in the private credit market. While both of these portfolio companies were successful investments for SLX, generating mid-teens IRRs on a gross unlevered basis.
We passed on the refinancing transactions given the reasons Josh highlighted earlier related to the importance of disciplined capital allocation. Another payoff during the quarter that illustrates a specialized theme within our portfolio was our investment in $0.99.
We leveraged our expertise in the retail asset-based lending space to form our original underwriting thesis back in 2017. Over the 6.7 year hold period, we worked alongside the borrower -- several amendments maturity extensions and restructurings ultimately resolving you and co-founder for bankruptcy under Chapter 11 in April.
To support the company, during the case SLX provided a DIP term loan that was funded in April and repaid in June. We generated an unlevered gross IRR of 12.7% for SLX shareholders on the total investment including a 12.0% IRR on the original term loan and 55.7 IRR on the DIP term loan.
While this opportunity set as inflows, we've seen increased more recently driven by shifts in consumer demand for goods and services and more specifically to experiences. Post quarter end, we funded a new investment in this theme and expect to see this trend continue in the second half of the year.
From a portfolio yield perspective our weighted average yield on debt and income-producing securities at amortized cost declined slightly quarter-over-quarter from 14.0% to 13.9%. The weighted average yield at amortized cost of new investments including upside was for Q2 was 12.5% compared to a yield of 14.1% on fully exited investments.
To provide some color on investment portfolio today, credit quality remains strong with total non-accruals limited to 1.1% of the portfolio by fair value. Our internal risk rating improved quarter-over-quarter from 1.15 to 1.14 with one being the strongest.
Overall, we are pleased with the performance of our portfolio companies and feel that the management teams of our borrowers have been generally successful in executing on cost cutting initiatives and managing liquidity through a challenging operating environment.
We have not experienced a material increase in amendment requests related to covenants or liquidity which is another positive indicator of the health of the portfolio.
On a weighted average basis across our core portfolio companies continued top-line growth of approximately 4% quarter-over-quarter has contributed to deleveraging and sufficient liquidity, despite higher interest costs.
While spread tightening has led to an increase in repricing requests, this has largely come from portfolio companies demonstrating strong growth momentum and robust performance.
Moving on to the portfolio composition and credit charts across our core borrowers whom these metrics are relevant continue to have conservative weighted average attached and detached points at 0.6 times and 5.0 times, respectively and our weighted average interest coverage increased slightly from 2.0 times to 2.1 times quarter-over-quarter.
As a reminder, interest coverage assumes we apply reference rates at the end of the quarter to steady-state borrower EBITDA. As of Q2 2024, the weighted average revenue and EBITDA of our core portfolio companies was $310.4 million and $104.4 million, respectively. There were no new investments added to non-accrual status during the quarter.
With that I'd like to turn it over to my partner Ian to cover our financial performance in more detail..
Thank you, Bo. For Q1, we generated adjusted net investment income per share of $0.58 and adjusted net income per share of $0.50, total investments of 3.3 billion, down 1.9% from the prior quarter as a result of net repayment activity.
Total principal debt outstanding at quarter end was 1.8 billion and net assets were 1.6 billion or $17.19 per share prior to the impact of the supplemental dividend that was declared yesterday. Turning now to our balance sheet positioning.
Our debt to equity ratio decreased from 1.19 times, as of March 31 to 1.12 times as of June 30, and our weighted average debt to equity ratio for Q2 was 1.17 times. The decrease was primarily driven by our net repayment activity during the quarter.
As mentioned on last quarter's call, we closed an amendment to our $1.7 billion revolving credit facility in April including extending the final maturity on $1.5 billion of these commitments through April 2029.
We continue to have ample liquidity with $1.2 billion of unfunded revolver capacity quarter end, against $250 million of unfunded portfolio capital commitments eligible to be drawn. We are pleased with the strength of our funding profile heading into the second half of 2024.
Moving on to upcoming maturities, we have reserved for the $347.5 million of 2024 notes due in November, under our revolving credit facility.
After adjusting our unfunded revolver capacity as of quarter end for the repayment of those notes, we have liquidity of $862 million To go a step further, if we assume we utilize undrawn revolver capacity to reach the top end of our target leverage range of 1.25 times debt to equity and further drawdown for our eligible unfunded commitments.
We continue to have $398 million of excess liquidity. Beyond the 2024 notes. Our debt maturity profile is well laddered with maturities in 2026, 2028 and 2029 for our outstanding unsecured notes.
As we've said in the past, the unsecured market is our primary source of funding and we continue to have access to this form of financing at levels that have increased in attractiveness over the course of the year.
We have been pleased to see the broader development of the unsecured market over the last few years and view it as a positive for TSLX and the sector. Pivoting to our presentation materials. Slide 8 contains this quarter's NAV bridge, walking through the main drivers of NAV growth.
The over-allotment shares issued in April related to our equity raise in February resulted in $0.02 per share uplift to NAV in Q2. We added $0.58 per share from adjusted net investment income against our base dividend of $0.46 per share.
There was a $0.03 per share positive impact to NAV, primarily from the effect of tightening credit market spreads on the fair value of our portfolio. Net unrealized losses from portfolio company-specific events resulted in $0.08 per share decline in NAV.
This was primarily related to the markdown of our investment in lithium technologies from 91.25 to 76.75 quarter-over-quarter. The company has not performed as expected. And our fair value mark reflects this assessment. At this stage, the company is in the middle of a strategic process and there is a range of possible outcomes.
Other changes included $0.05 per share reduction to NAV as we reversed net unrealized gains on the balance sheet related to investment realizations and $0.02 per share uplift from net realized gains on investments primarily from structured credit sales during the quarter. As for our operating results detailed on Slide 9.
We generated a record $121.8 million of total investment income for the quarter, up 3% compared to $117.8 million in the prior quarter. Interest and dividend income was $112.2 million, slightly above prior quarter of $112.1 million.
Other fees representing prepayment fees and accelerated amortization of upfront fees from unscheduled paydowns were higher at $4 million compared to $1.5 million in Q1, driven by increased activity base fees from the elevated repayment activity experienced during the quarter.
Other income was $5.5 million compared to $4.3 million in the prior quarter.
Net expenses, excluding the impact of the non-cash reversal related to unwind capital gains incentive fees were $66.8 million, up slightly from the $65.4 million in the prior quarter, driven by expenses incurred during the quarter of the annual and special shareholder meetings that were held in May.
Our weighted average interest rate on average debt outstanding increased slightly from 7.6% to 7.7%, driven by our funding mix shift towards unsecured financing given net repayment activity led to lower outstandings on our lower-cost revolver.
Following the repayment of the 2024 notes in November, there will be a small positive economic impact of almost $0.01 per share quarterly in 2025 as the implied funding mix shift will lower our weighted leverage cost of debt. Before passing it back to Josh, I wanted to circle back to our ROE metrics.
For the year-to-date period, we generated annualized adjusted net investment income of $2.32 per share, corresponding to a return on equity of 13.7%. This compares to our previously stated target range for adjusted net investment income of $2.27 to $2.41, corresponding to a return on equity of 13.4% to 14.2% for the full year.
We maintain this outlook heading into the second half of 2024. With that, I'll turn it back to Josh for concluding remarks..
Thank you, Ian. During this time of significant growth in the private credit market, it's no surprise that competition has increased and spreads have grinded tighter. As an investment manager, we view this time as an opportunity to further differentiate our business as being not only disciplined investors, but disciplined capital allocators.
To us, that means having choices regarding what to invest in and when to invest. We create this optionality in our business in two ways. First, we size our capital base to the opportunity set.
This means running a constrained balance sheet such that we can operate within a target leverage range without broader market participation in deals that we do not think present appropriate risk-adjusted returns or meet our required return on equity.
We accomplish this objective by taking a thoughtful approach to growth regardless of our ongoing ability to raise capital. And second, is investing in a platform that has a wide origination funnel. Despite the competitive drug lending backdrop that exists today, we remain active, yet selective, because of the benefits of the 6G platform.
This wide range of deal flow allows us to make calls on relative value, toggle between large-cap and middle-market exposure, lean into sector themes and most importantly, pass on investments that do not meet this return and ask for return profiles determined for our shareholders.
As disciplined investors, we make these choices with shareholder returns top of mind, which we believe leads to better credit structures and ultimately translates to a lower credit loss over the long term and better shareholder experience. With that, thank you for your time today. And operator please open the line questions..
Thank you. At this time, as mentioned, we'll now conduct a question-and-answer session. [Operator Instructions] Finian O'Shea WFS. Your line is now open..
Hey everyone. Good morning. Taking some of the opening comments on the market. There's I think a rapid change in private credit. You noted assuming that references the amount of capital that's been raised and so forth.
And then then how you're passing on a lot of deals but due to yield the cost of capital down, would you say this relates to the deals you're passing on? Does it relate to market deterioration in credit underwriting or are there more firms out there that can do complexity at scale?.
Hey Fin. Good morning. So, it's in the straight kind of sponsor stuff. So, the vanilla stuff, I think I would flag two things.
One is that our concern is that really credit deterioration or credit underwriting deterioration even in those deals is just that that sector BDC, specifically, given where they bought all the amount of capital they have to hold i.e. they can only be 1.25 times leverage and fees and expenses.
All that good stuff puts them at a place in the cost curve for those assets at certain prices no longer create a return on equity that meets or exceeds the cost of equity of the space. So, we find that in the sponsor stuff.
If you look at our -- you were talking about our spreads for this quarter which is predominantly sponsor stuff, which was I think above the sector and above our earnings our cost of equity, if you look at what we funded quarter-to-date seen a 20 basis -- 20 or 30 basis points wider than that.
And if you look at what's in the pipeline it's significantly wider than that because it has shifted from sponsor to non-sponsor stuff. And so for example in a pipeline is like 860 spread and that's before fees and that's predominately non-sponsor stuff. So, I think it's mostly in the sponsor stuff.
And again I think the relationship of how the size of the origination platform your capabilities compared to the size of your capital is really, really important and being able continue to create shareholder value..
Very helpful. Thank you. And some follow-up on Europe that would seem to be most of your new deals this quarter.
Can you remind us of the footprint you have there? Is there growth in that or was this more, those were the best deals you saw this quarter from the market?.
Yes. So look we're I would say when you look at you're up from I think what you're referring to by number, but probably not necessarily by dollar amount. And so by dollar amount, I don't think that's a true statement by number.
That is a true statement under the exemptive relief strategy is, we want to make sure SOX as the ability to continue to invest and deals and so and if I take a position day one and those investments and so a lot of those positions that you're referring to are small kind of toehold positions. Our platform in Europe is growing has been very successful.
We've been in that market for a long time. And quite frankly in the moment the risk return better on the fossil stuff is better in Europe than it is in the US. I think you would agree with me on that took the US for sure.
So -- but again I think it's by number not by dollar, by dollar predominantly US, it still we like the risk return for example one of the larger things we did was add event which was a buyout of the on kind of the eBay auction assets in Europe. And that has a nice spread compared to what you can find the US..
Thanks so much..
Thanks, Fan. Have a good day..
Thank you. Our next question comes from the line of Brian Mckenna with Citizens' JMP. Your line is open..
All right. Thanks. Good morning everyone. So you've talked a lot about the turnover within the portfolio since the Fed started beginning raising rates. You've recycled a lot of capital over the past few years. Obviously, that's been good for the portfolio repositioning.
But how should we think about the turnover from here? And this continued rotation into new vintages of loans? And then I guess what does all that mean for kind of the underlying performance of the portfolio from here?.
Yes. Hey Brian. So I would frame it. So just, I would say that -- I think the premise is slightly wrong which is -- the portfolio which is nice, which is mostly post rate hiking cycle vintage was predominantly driven by that we were slightly below our target leverage going into the rate hiking cycle. Plus we did -- we were able to raise that.
We had a convert and I think we did a two equity raises. So it's really that it wasn't the portfolio rotation with the portfolio composition changed not because of turnover. Turnover has been light post rate hiking cycle and you can see that -- in starting to pick up but you can see that actually in the activity-based fees.
I think going forward as I said pivots which you if silver takes it up to pivot in September, deal activity picks up, spreads coming -- spread have already started to come in, but deal activity picks up, my guess is there will be more natural kind of turnover and the portfolio which will go from an economic basis in the short term, SLF shareholders will benefit from because activity is a seasonal pickup.
You saw was activity-based fee pickup. So this is the first quarter we had a little bit of we had a little net repayments and activity based fees picked up this quarter slightly along with that..
Okay, helpful. Thanks. And then just a bigger question here, Josh, will be great. Just get your thoughts on the broader macro. You're clearly there's a lot of puts and takes, takes looking out over the next year, a lot of term rates have come in quite a bit recently. There's likely going to be several rate cuts into 2025.
Capital markets activity is accelerating. Public equity and credit markets are performing well, but it does seem like the economy is slowing here.
So how are you guys thinking about the macro over the next year, and what's the base case expectation for some of these moving pieces when you're underwriting new deals today?.
Okay. So it's a tricky. It's a tricky environment. Actually I'm pretty bullish about the vintages of today. Those vintages are based on are underwritten in that higher rate environment where you have had a tailwind as the cutting rate is and the stimulus of demand that comes with a rate cut.
So you got to be bullish on the last couple of years' vintages and post-rate hiking cycle, given the underwriting standards that improved, there was rate clarity, and you were in a tightening cycle. So I think that is helpful. I think the recent vintages will perform really, really well.
But there's going to be tails, and the tails are going to be in the previous vintages. You're most definitely starting to see that. We've talked about this for, like, three quarters, which is this idea of tails and the divergence between operating ROEs, which will be higher than total economic or gas ROEs, so the difference between NII and NIA [ph].
And you see that a little bit. I think you'll see that continue a little bit. So I -- but I'm -- the economy is most definitely stopping, which is allowing the Fed to pivot. The Fed pivots, which should loosen financial conditions. Those should spur demand and get the economy going again at a stable level. So I'm relatively constructive on the macro.
There's most definitely going to be tails, and there's most definitely going to be cohorts of, like, the consumer, especially the lower end, that the world will be pinch points and pain points.
And then, obviously, geopolitical, who knows?.
Yep, got it. All right, great, thanks. I'll leave it there. Appreciate it..
Thanks. Have a good day..
Thank you. Our next question comes from the line of Mark Hughes with Truist Securities. Your line is now open, Mark..
Yeah, thank you. Good morning. You're on the deal flow..
Good morning..
Good morning. Your rate on the deal flow, good morning.
Has that changed materially over the last six months? If you're having to be more selective, how is that working out in terms of your success rate?.
Yes, I would say, look, when you look at Q -- I'll say generally our hit rate probably is materially a little bit lower, maybe. I mean, I think what's changed is there's credits we like at prices we don't. And we're very cognizant of driving shareholder return and return on equity.
And that's the things we do today will generate the return on equity for 2025 and 2026. And even though that we have a back-book with a higher yield we want to be cognizant of making sure we earn our return on equity. So I think our hit rates are similar except that there are things that we like the credit and we just don't like the prices..
Yes. The average commitment this may be just the unfair snapshot, but the average commitment was lower in 2Q say compared to 4Q.
Are you seeing more opportunity the smaller end of the market?.
No. I mean, no that's a reflection of the co-investment strategy where in European deals or large-cap deals in SLX for European yields is taking a smaller position. And so there's like a whole bunch of on the European deals like $5 million to $6 million are dragging it down.
But if you look at like the core positions like Marriott at events those are you know kind of $35 million -- $40 million commitment.
So it's is that a little bit more of that participation and how the co-investment -- the new co-investment order rates?.
Yes. I think you mentioned the word toe-hold..
Yes..
And then final question, the – you described how the spreads in the pipeline are looking better as you've shifted from the sponsor to non-sponsor.
Is that the broader market helping support that? Or is that more intentionality on your part?.
I mean the great thing about being part of as you well know Sixth Street is a $80 billion platform and having this wide aperture that you know, we get the toggle between things. So we did this quarter non-sponsor, we did Apellis which was a healthcare spec pharma deal. We like that space. We like -- I think there's probably more to come.
We did a retail ABL financing that consumers we can -- [indiscernible] capital again and that was done post quarter end which was a non-sponsored deal. So at we were you know we kind of the great news is having big white top of the funnel as we can to be picky and choosy in making sure we're driving shareholder return..
Okay. Appreciate it. Thank you..
Thanks. Have a great day..
Thank you..
Thank you. Our next question comes from the line of Mickey Schleien with Ladenburg. Your line is now open..
Yes. Good morning, everyone. And Josh not to beat a dead horse here, but I wanted to ask you a follow-up question on spreads.
Do you think that it's just this issue of a massive supply of private debt capital that overwhelming the potential for the Fed to cut rates that's causing this spread tightening? Or do you think we're approaching some sort of a floor?.
It's a great question, Mickey. And by the way it's good to hear from you. I don't think we heard from you last one or two earnings calls. So it's good to hear your voice. You always have very good questions. My sense is the private credit, private capital has been institutionalized.
There was a lot of allocators that had now understand the value proposition. So they've allocated capital. And so that's on the supply of capital. On the demand for capital, given the M&A environment, there wasn't that natural demand from M&A.
And so -- my sense is that we'll get back in equilibrium here shortly with the Fed cutting and more M&A picking up. And so -- but we were kind of in this -- the supply kind of outpaced demand early on. And we've always wanted to be very disciplined. And the incentives for managers to put that to work and earn fees, et cetera.
Those are real incentives and we've always tried to fight those -- acknowledge those incentives and fight dose incentives and think about the long-term of shareholder experience.
So my hope is that with more demand coming from a loosening environment driven M&A and will drive investment and CapEx growth that the supply and demand kind of will get more imbalanced..
That's good to hear.
And if I could follow up, Josh, with this sort of disintermediation of the commercial bank that's occurred over the last many years in the private credit, do you think what do you think the probability is that we'll see more regulation of private credit? And do you think there's systemic risk developing that will come to light down the road?.
Yeah. Look, I have a whole thing about this. So the specific risk point is a little bit silly. And I think the first thing I would say is that unlike the banking system, the taxpayers have written a put for private credit.
And specific risk we cause comes from a little bit of that -- some of that put obligation for taxpayers and that is effectively through the FDIC program, backstop asset choices for banks. The second thing is most systemic risk has come from an ALM issue and -- which is that people are long assets and short liabilities.
And that does not exist in private credit and private credit match funded, there's no ALM. We talked about the soften, but I think the average life of our assets when leverage is like two and half year versus leverage is like four years. And so we actually have small reinvestment risk, let alone liquidity risk.
And that's where most kind of systemic or issues have come with financial institutions. The third thing I would say is PDP specifically in private credit as compared to the banks hold somewhere between four, three and five times amount of capital spend. And so risk-bearing capital on BDCs are about 45% to 50%.
If you think about one times leverage or 1.1 times leverage and bank sale about 8% capital. And so the idea that there is real systemic risk overall with the loss of shareholders, given the higher capital and private credit feels off to me as well. I started this conversation with the idea of return on equity, and I would do this analogy for people.
If I would describe two business models for listeners, one business model is that you win long -- you own 8% capital, you win long, you borrow short.
The other business model is you hold 50% capital, you are totally match funded, and I would say academically, what would be the required return on equity of those two business models? My guess is you would say the required return on equity would be a lot lower for the latter business model, the private credit business model. That's actually not true.
The private bank's return on equity requirement of private credit and BDCs are about the same, which the business model of private credit is a much more robust business model given the amount of capital and the robustness of the ALM.
Is that helpful, Mickey?.
That's very helpful. And I appreciate your clarity on that. And my last question, Josh, just switching gears. Lithium Technologies, which I think is part of corals, if I'm not mistaken, is a customer care, software-based customer care company. I realize that at any moment in time, credit can run into headwinds.
I'm more curious whether there's something underlying the headwinds at Lithium that would cause you concern over the sector in general, because that is a focus of yours, and as well, other BDCs..
Yeah. Lithium is purely idiosyncratic. So it probably, like, the one thing I would be critical on the margin of us in this space is that when COVID hit, everybody thought about businesses that were negatively impacted by COVID. There were some businesses that were positively impacted by COVID.
This was a software business that had a levered engagement online and through social media platforms. That was probably a positive tailwind that's unwound, so it's purely idiosyncratic..
Okay. I appreciate that. That's all for me this morning. Thank you for taking my questions..
Thanks, Mickey..
Thank you. Our next question comes from the line of Kenneth Lee with RBC. Your line is now open..
Hey, good morning. Thanks for taking my question. Sounds like in terms of the new originations, new investments you're seeing, there might be a little bit of a spread tiny across the industry. I wonder if you could just comment about what you're seeing in terms of documentation and terms on some of these newer deals, seeing any changes more recently.
Thanks..
Yeah, look, I would say document, stocks have been pretty stable. So I think underwriting standards remain good in private credit.
I mean, the question again is, is like where we sit on the cost curve, what's the required spread during your cost of equity? And if I was critical in one place, it would be people not understanding where they sit in the cost curve or where they're leaning too much into their back book. But the things you do today are the ROEs in 2025 and 2026.
But the way to average financial covenants and all that stuff is basically the same. The docs are in pretty good shape. That's right..
Great. Very helpful there.
And just one follow-up, if I may, just more broadly in terms of the more complex investment opportunities, is this something where we have to wait perhaps for a more of a macro slowdown before you start seeing more opportunities there? Or could we see a potential pickup in complex -- more complex investment properties when M&A activity rebounds as well.
Thanks..
Yeah. Look I think it's I think it's, again I think the complexity is, I think there's two things. One is that tails -- we live in an environment with low rates, capital get allocated very poorly. That complexity is going to come from that pipeline of yesterday's mistake. And that's going to be there no matter what.
And then I think offer a tailwind as M&A picks up. People will know some of our competitors are a lot of our competitors. Quite frankly that stuff is easier to prosecute with less people and so their eyes will go that way.
And so I think you have two kind of compounding effect, which is the tails are growing, which will provide opportunity for us and complexity and as M&A picks up people's natural kind of a glare will be focused on that. And so I think I'm pretty bullish about the next couple of years for our complexity..
Great. Very helpful. Thanks again..
Thank you. Our next question comes from the line of Paul Johnson with KBW. Your line is now open..
Good morning. Thanks for taking my question.
So just with the development of liability management exercises and development recently Pluralsight realizing obviously process not a newer portfolio, but I'm just wondering your thoughts on weather those type of events increase the risk of sponsor concentration issues where you have an adverse event with one of your common partnering sponsors and there's risks to deal flow as well as just kind of the calculus of working within lender group as well?.
Yeah. So, look, I don't really have anything to add in Plural. So we're not we're not that involved. We were involved, not that we’re not that involved. We were involved. So I can't add anything specific.
I would say my understanding of that situation seemed like a -- it was I thought that was kind of not -- was slightly outside the range of the existing dock service adoption our portfolio as I understand it.
And the good thing is, is that it wasn't done, there was no lender or lender violence that existed like you see in the broadly syndicated more loan market where there's a prisoner's dilemma, which is if I do it, because if I don't do it, somebody else will do it and that didn't exist. So and then you're also seeing.
So I think that I don't see that as a big, I think as a overblown concern and private credit. On the sponsor concentration, which I'm not sure they're exactly related. We don't really have a sponsor concentration over. Historically, we've got about 55% sponsor staff, 35% non-sponsor and existing book today we have no sponsor above 10%.
So it's and we have like 45% or 30% sponsors in the group. So I don't -- I'm not -- I don't see them related um but I think I answered your question. That's helpful..
Yes, it's very helpful. I appreciate that.
I mean do you think that that an event like that is just the result of that credit underlying bad that documentation or is this lawyers that are basically at fault here?.
Yes, I would never blame. I can't really speak to I don't to speak to close. I'm not involved. So, I don't have we know that things are going to happen in our business. I think you know we've been very good on the credit side and stuff pops up still.
So, think it's going to happen you know like part of part of our business is a little bit about a lot of our business -- only thing about this is about figuring out what the future looks like in trying to use historical and industry structures as an analog for that.
And so we're in underwriting the future because values abate based on future cash flows and how the business performs future and feel on the margin sometimes you're going to get it wrong.
And that's I think that's important as it relates to industry is a function of where you invest in the capital structure but I can't speak to Pluralsight specifically I appreciate that..
Got it. Appreciate that. Yes, I was just kind of asking a little bit more broadly on the space, but appreciate the answers.
I would never blame something on the service provider work. So, we're principles we own we own or decisions. So, I -- like lawyers -- tough to blame on lawyers, there are service providers were principles. And so when there's a mistake, I own it, we own it as a team..
Thank you. Our next question comes from the line of Melissa Wedel JPMorgan. Your line is now open..
Good morning. Thanks for taking my questions. Most of mine have actually been asked already. A quick clarification.
When you talked about the pipeline know kind of going forward, did you miss it or did you find that at all for us?.
Yes, I'll have a quick look that -- I missed it is probably like the near-term stuff is a couple of hundred million bucks like in the -- that -- in this next kind of quarter. I think it if that's helpful on the gross side before repayments..
Yes. Got it. I appreciate that. And then separately on kind of digging into the non-sponsor side a little bit when -- we hear non-sponsor I tend to think as that tend to be a little bit smaller companies, they tend to be a bit better on spread as you specifically mentioned.
But then I'm also curious is that take longer for your team to sort of diligence and close it or do those investments? Is the time line any different for you versus some of the larger more maybe owned equipment syndicated across a few Wonder type deals and sponsor deals that you have for I would say the barrier to entry for why I think we see less competition..
Yes, so I would say the barrier to entry for a while -- give you less competition is for the major -- it is a much more difficult, less profitable business. It takes longer. It takes more resources. It takes more time both on the enterprise side, on the asset management side. And so it is in the average life tends to be shorter.
And so the return on capital for the management company is a lot lower. The return on capital for our shareholders is a lot higher.
And so it's – I think that's why historically, if you need specialized resources, people one-tenth of the example I gave the people on the ABL stuff, the ABL stuff, the average life is you know everybody knows understands the fees in our business but if you could earn x fees on something that has an average life of three years.
And it's a lot easier to persecute and earning the same fees on something as that average life of 1.5 years then it was a lot harder to persecute -- it's not shocking what people do. They’re not smaller. Actually, sometimes bigger. A lot of times bigger. And the only thing we'd add is – is that these are not necessarily small opportunities.
These are large businesses generally..
Got it. And is the use of funds is what strategic M&A or other.
No, balance sheet restructuring is sometimes exiting of bankruptcy, sometimes it's entering a bankruptcy and a debt. Sometimes it's a bridge to somewhere, but they don't know exactly where somewhere is because we have an over-levered balance sheet like Ferrellgas.
They didn't really know when we do that deal were that over lever balance sheet, we were the senior secured. They don't know exactly where it was going. So it's a whole host of things. In our Tech Pharma [ph] R&D sorry, development or Tech Pharma..
Appreciate it. Thank you..
Thank you. Our next question comes from the line of Bryce Rowe with B. Riley. Your line is now open..
Thanks a lot. Good morning. Maybe I wanted to offer one follow-up to Melissa's first question there. Helpful to -- for you all to kind of size up the portfolio in terms of the gross potential at least over the near-term. And you certainly have talked about the potential for increased repayment activity.
This year, we saw a little bit of it in the second quarter. Kind of curious how you kind of balance or handicap the second half of the year from a net perspective.
Do you think that you'll continue to see some of this repayment activity that will offset originations or possible to see some net growth?.
Yes. I think our base cases were kind of net flat, flattish, Ian. So growth originations will pick up as activity levels pick up, repayments will, which will create economics in the books. But I think it’s net flattish, which we think is good.
I would like to have being kind of the -- in our debt-to-equity of where we are today, which will give us room when there's big opportunities to actually participate in them..
Yes. Okay..
Without having any new equity..
That's helpful, Josh. I appreciate it. And maybe a question around some -- I think it was both that made the comment, but the comment around lower rates possibly driving more deal flow at some point in the future.
Can you kind of expand on your thoughts around what kind of environment behind the lower rates we have in driving that -- I guess, that type of deal flow? And I guess I'm getting at whether we actually get a real credit cycle for the first time in 15, 20 years and kind of what that might mean, at least on the onset of the lower rates and how deep those rates get?.
Yeah. Look, I don't feel real like 2001, 2008 credit cycle. I just don't see that. But I do think you have elevated tails. Businesses has performed relatively well. The portfolio is growing, is growing -- when you look at last quarter, it's growing year-over-year, quarter-over-quarter.
So I think that to the Fed's credit, they've done a reasonably good job of trying to kind of get into the soft landing.
So I don't see a real credit, but I do see that when you take a step back, that capital pre-COVID post-COVID was misallocated which will -- which has created a tails while you had basically 0% to 1% interest rates for a long period of time.
And so there has to be a reckoning to some of that allocation of capital, but I don't see a deep credit cycle given that businesses have been able to kind of continue to earn the consumer has been relatively strong. I think the Fed actually found a pretty decent balance..
Great. I appreciate the perspective..
Everybody likes to be critical of the Fed, but I think they've actually found -- it feels like they've found a pretty decent balance..
Got it. Got it. Thank you..
Thank you. Our next question, which is our last question comes from the line of Robert Dodd with Raymond James. Your line is now open..
Thank you. Good morning. Bryce Rowe actually just asked the main question. So about growth. So kind of a little add-on to that. You mentioned if you kind of flat this year, should we expect that to be a result of a little bit of rotation. I mean, you talked about more non-sponsored in the quarter coming up.
Is that going to be a theme this year more non-sponsored maybe more complex deals? But then those turn faster. So what's the maybe not just this year, but do you expect that you'll see more of that then they'll turn faster in 2025, 2026.
And then you really need the sponsor market pricing to become more acceptable over some period of time in order to keep the portfolio at the front..
Yes. Scale is, first of all, -- okay, for us is really how is -- let me tell you philosophically how we set up our business because we answer as -- I don't know. And if I sit here and tell you what I know exactly how it's going to play out, it's kind of silly. Not the question but just that I have the answer to the question.
To me, we've set up our business where we have created a whole bunch of options for shareholders on different strategies non-sponsored healthcare, spec pharma, retail, sponsored energy and we go from the top of the funnel.
And as allocators of capital we have to say where does it overlap with a really good risk return on an unlevered basis and where they provide significant shareholder value and meet the return equity requirements of our shareholders and like. So we really like that model, because that model allows us to drive.
We've been a public company now for 10-plus years and we've been able -- I think it feels longer to be honest with you, is that we've been able to drive shareholder value, because of that combination of constrained capital top of the funnel and the options of what we can pick.
And then the acknowledgment of where we sit on the cost curve and our return on equity, like that to me is that is a formula. Now, do I know exactly what options are going to be in the money and the top of the funnel, I don't know..
Fair enough. Thank you..
Awesome. It’s good to hear your voice, Robert..
Thanks..
Thank you. I'm showing no further questions at this time, and I would now like to turn the call back to Josh Easterly for closing remarks..
And look, we all appreciate everybody’s thoughtful and engaging questions. And I hope everybody has a great end of the summer with their families. And we’ll talk in November and it's going to be a crazy November my guess. So, thank you. We're always around. We love the engagement and we'll keep working hard for our shareholders. Thanks..
Thank you. And this does conclude the program and you may now disconnect..