Sixth Street Specialty Lending - Q1 2023

Transcript

Operator (participant)

Good morning, welcome to the Sixth Street Specialty Lending, Inc.'s first quarter ended March 31st, 2023 earnings conference call. At this time, all participants are in a listen only mode. As a reminder, this conference is being recorded on Tuesday, May 9th, 2023. I will now turn the call over to Ms. Cami VanHorn, Head of Investor Relations.

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 first quarter ended March 31st, 2023, 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 first quarter ended March 31st, 2023. 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.

Joshua Easterly (CEO)

Thank you, Cami. Good morning, everyone, and thank you for joining us. With us today is my partner and our President, Bo Stanley, and our CFO, Ian Simmonds. For our call today, I'll provide highlights for this quarter's results and then pass over to Bo to discuss activity levels in the portfolio. Ian will review our quarterly financial results in detail, and I will conclude with final remarks before opening the call to Q&A. After market closed yesterday, we reported first quarter financial results with adjusted net investment income per share of $0.55, corresponding to an annualized return on equity of 13.3% and adjusted net income per share of $0.67, corresponding to an annualized return on equity of 16.3%.

From a reporting perspective, our Q1 net investment income and net income per share, inclusive of accrued capital gain incentive fee expenses, was $0.53 and $0.65, respectively. As a reminder, the $0.02 per share is a non-cash expense which was not paid or payable and is related to accrued fees on unrealized gains from the valuation of our investments. This quarter's net investment income reflects the continued strength in the core earnings power of our portfolio, and the annualized ROE metrics are above the guidance we provided on our last earnings call. Net investment income was largely the result of elevated portfolio yields driven by higher underlying reference rates. Activity-based fees represented only 3.6% of total invested income for the quarter.

Year-over-year, total invested income has increased 43%, largely driven by asset sensitivity from higher interest rates in our floating rate investments. We expect that the interest rate environment will continue to support core rates without the impact of any activity related income based on our base dividend level. Further, we believe there is potential upside relative to this quarter's 13.3% annualized return on equity on adjusted net investment income as we generate incremental earnings from payoffs and other activity-based fees. The difference between this quarter's net investment income and net income was predominantly a result of unrealized gains from tightening credit market spreads on the fair value of our portfolio and realized gains from certain portfolio company specific events. From a macroeconomic perspective, to say 2023 is off to an eventful start is an understatement.

Through the first quarter of the year, we've experienced financial contagion fears following the regional banking issues, persistent inflation, sustained rising interest rates, and ongoing geopolitical factors, just to name a few. As part of our commitment to transparency in our communications with our stakeholders, during March, we published a letter outlining the positioning of our business as it relates to the most recent developments in the banking sector. We encourage you to read our perspectives and welcome any feedback. For today's call, we will keep it simple by saying we don't believe there are any material impacts to our business from these developments. If we take a step back and consider all the opportunities and challenges presented by today's macro landscape, we believe that TSLX is well-positioned.

We have built a defensive through the cycle business characterized by investors on top of the capital structure with low exposure to cyclical businesses. Although our portfolio construction is bottoms-up in nature, we continue to be mindful of the impact of certain macroeconomic indicators that can influence both the performance of our existing portfolio and the opportunity set ahead of us. At quarter-end, net asset value per share was $16.59, up $0.20 per share or 1.2% from adjusted net asset value per share at year-end of $16.39. This growth was primarily driven by continued overearning of our base dividend and net unrealized and realized gains from investments. Yesterday, our board approved a second quarter base quarterly dividend of $0.46 per share to shareholders of record as of June 15th, payable on June 30th.

Our board also declared a supplemental dividend of $0.04 per share related to our Q1 earnings to shareholders of record as of May 31st, payable on June 20th. Our Q1 2023 net asset value per share adjusted for the impact of the supplemental dividend is $16.55. We estimate that our spillover income per share at quarter end is approximately $0.87. As part of our focus on capital efficiency, in conjunction with our board, we will review the level of undistributed income as the year progresses to ensure we minimize potential return equity drag from the resulting excise tax. At some level, this will likely require the payment of additional distributions to our shareholders, similar to how we addressed this in 2020 and 2021. With that, I'll now pass it over to Bo to discuss this quarter's investment activity.

Bo Stanley (Partner and President)

Thanks, Josh. I'd like to start by sharing some observations on the broader market backdrop, in particular, the secular shift towards private credit that has been a persistent theme over the last few quarters. We believe the opportunity set for our business is the greatest we've seen in recent history, at least since the global financial crisis. The developments in the financial sector have further increased market share for direct lenders as banks are tightening credit and public markets remain unreliable in light of heightened economic uncertainty. As a result, nearly every financing opportunity is coming to the private credit market due to the flexibility and execution certainty that direct lenders with capital are able to provide. This shift has been a positive for our business as we continue to build a robust pipeline while remaining selective.

Broadly speaking, M&A and LBO activity have meaningfully slowed, but the scale and quality of companies we're financing has generally improved given the shift towards private credit. We remain active during the quarter, with commitments and fundings totaling $176 million and $139 million, respectively. This was distributed across seven new and five upsizes to existing portfolio companies. On the repayment side, higher interest rates and the lack of more traditional capital market financing alternatives have led to a slowdown in refinancing activity, resulting in less portfolio turnover over the last couple of quarters. We had one full and three partial investment realizations totaling $51 million in Q1. Consequently, activity-based fee income remained muted. Our full payoff during this quarter was our investment in WideOrbit, which is a provider of TV and radio traffic management software.

As a reminder, we made our initial investment in July of 2020 in a COVID-driven market dislocation. Our ability to play offense during this time not only benefited the company in its need for refinancing, but also allowed us to structure the transaction with favorable terms for shareholders, including potential upside through ownership of warrants. In February, the company was acquired by the Lumen Group, which included a repayment of the outstanding balance on its credit facility and proceeds to outstanding warrant holders. TSLX received $5.2 million in proceeds from the sale of our warrants, resulting in a realized gain of $4.8 million, or $0.06 per share, and generated a blended IRR and MOM on our total investment of approximately 17% and 1.4x, respectively.

To touch on investment themes during the first quarter, sponsor activity in the upper middle market remained active given the uptick in public-to-private transactions. More broadly, across the middle market, activity levels were generally slower in Q1, but for the deals that were getting done, capital scarcity at size created an opportunity for our business due to a substantial pool of capital across Sixth Street's platform. One example that highlights this theme was our investment to support Thoma Bravo's take private of Coupa Software. With a total transaction value of $8 billion, Sixth Street played an important role in providing financing given the size of our capital base and knowledge in the software space. Both of these differentiators, in addition to our relationship with the sponsor, allowed us to structure and lead the underwriting process.

In addition to making new investments, we remain very focused on active portfolio management, including monitoring the health of our existing portfolio companies. Elevated interest rates and sustained inflation have created a more challenging operating environment, especially for those with high fixed cost obligations. 82% of our portfolio by fair value was characterized by software and business services companies as of quarter end. We favor the durability we see in these sectors, in particular, given the variable cost structure provides the flexibility to implement more immediate cost savings in the event bookings or top-line growth slows in an environment of broader economic slowdown. To date, the performance of our portfolio companies remains solid, demonstrated by quarter-over-quarter revenue and EBITDA growth of 9% and 17% respectively.

As Josh mentioned, we've constructed a portfolio to withstand all types of operating environments, and we feel good about the overall health of our current portfolio. I'd like to take a moment to provide an update on one of our existing investments, Bed Bath & Beyond. As publicly disclosed on April 23rd, Bed Bath & Beyond announced that it would be voluntarily filing for bankruptcy to implement an orderly wind down of its business while conducting a limited marketing process to solicit interest in one or more sales of some or all of its assets. This filing, and the voluntary nature of it, is a positive development for our investment.

Instead of the company potentially attempting to fund continued losses, we believe a shorter time period optimizes recoveries on our collateral and for creditors in general. The company also announced that Sixth Street, as agent of existing five other lenders, would be contributing $240 million in debtor-in-possession financing to provide liquidity for operations through the Chapter 11 process. The DIP is comprised of $40 million in new fundings, of which $5.9 million was funded by TSLX, with the rest being a rollover from previously funded commitments amongst the lender group. Including our position of the DIP, TSLX has funded $76 million related to Bed Bath & Beyond to date since our initial investment in September 2022. At this moment, we feel confident about the recovery of our investment at fair value.

We would also note that there is potential upside above fair value as our total claim amount includes previously capitalized made whole amounts which could positively impact earnings in the range of zero-10 and a half cents per share net of incentive fees. When we made our initial investment, it was to provide liquidity and to support the turnaround of an iconic brand which we felt had real potential to rebound if the right strategy was put in place. Unfortunately, that hasn't happened. With a 50% drop in same-source sales during last year's holiday season and significant operating losses in Q1 were too much to overcome for the business to continue in its current form. While liquidation was not the desired outcome, it was the base case from our underwriting approach. As we have demonstrated before, we have core competency in these situations.

Since we began investing through TSLX in 2011, we have executed over 25 transactions in our retail ABL team. In each case, we underwrite with a liquidation scenario in mind. We have taken nine of those 25 investments through the bankruptcy process. These processes are always fluid, with this one being no different. We continue to work diligently to maximize value for our investors. Our recoveries will ultimately be based on the underlying liquidation value of the assets of the business which we will have more refined view on over time. We anticipate the liquidation process to take approximately 16-20 weeks. Heading into the rest of 2023, we saw a pickup in activity beginning in March. We are optimistic about our originations and funding costs pipeline.

The fact that we are in a strong position from a capital and liquidity perspective, as Ian will discuss, provides us with meaningful competitive advantage in the current environment. As for repayment activity, we generally expect less churn in our portfolio through the course of the year. However, we do anticipate opportunistic and idiosyncratic events will drive payoffs. Deal flow and repayment activity are largely a byproduct of macroeconomic factors at play, but we continue to pick our spots and remain selective. We will opportunistically deploy capital in areas where our platform's ability to underwrite and navigate complexity allows us to create excess returns across our portfolio. From a portfolio yield perspective, funding and repayment activity this quarter had a positive impact to our weighted average yield on debt and income-producing securities of amortized cost.

Yields were up to 13.9% from 13.4% quarter-over-quarter and are up about 360 basis points from a year ago. The weighted average yield of amortized cost on new investments, including upsizes this quarter, was 13.8% compared to 13.2% on exited investments. Moving on to the portfolio composition and credit stats. Across our core borrowers for whom these metrics are relevant, we continue to have conservative weighted average attach and detach points on our loans of 0.8x and 4.4x respectively, and their weighted average interest coverage remains stable at 2.2x. As of Q1 2023, the weighted average revenue and EBIT of our core portfolio of companies was $165 million and $54 million, respectively.

Finally, the performance rating of our portfolio continues to be strong, with a weighted average rating of 1.16 on a scale of one to five, with one being the strongest. We continue to have minimum non-accruals at less than 0.7% of the portfolio at fair value, with no new portfolio companies added from prior quarter. The increase in the notional quoted value from the prior quarter reflects another tranche of our investment in American Achievement being placed on non-accrual during the quarter. This was a COVID-impacted business that has had difficulty recovering after missing 1.5 selling seasons and the relatively weakening of their competitive position in their industry. American Achievement continues to be our only portfolio company on non-accrual status. With that, I'd like to turn it over to Ian to cover our financial performance in more detail.

Ian Simmonds (CFO)

Thank you, Bo. For Q1, we generated adjusted net investment income per share of $0.55 and adjusted net income per share of $0.67. Total investments were $2.9 billion, up from the prior quarter as a result of net funding activity. Total principal debt outstanding at quarter end was $1.6 billion. Net assets were $1.4 billion or $16.59 per share prior to the impact of the supplemental dividend that was declared yesterday. Our average debt-to-equity ratio increased slightly quarter-over-quarter from 1.14x to 1.17x. Our debt-to-equity ratio at March 31 was 1.2x. The increase was driven by portfolio growth from new investments combined with minimal repayment activity.

After the recent announcement from Bed Bath & Beyond that Bo mentioned earlier, we now expect the $76 million in funded par outstanding to be paid down in the near term, thereby decreasing leverage and increasing our capacity for new investment opportunities. We continue to have ample liquidity with $603 million of unfunded revolver capacity at quarter end against only $190 million of unfunded portfolio company cap commitments eligible to be drawn. As part of the letter to our stakeholders we published in March in response to the failure of Silicon Valley Bank, we shared aspects of our philosophy towards managing risks in our business. As we've witnessed through the last couple of months, it is not enough to merely satisfy minimum regulatory requirements. It is in the corner cases, the shocks, where the strength or weakness of the operating model is truly apparent.

An understanding of this concept has guided the way we have structured our balance sheet in terms of both capital and liquidity. As it relates to capital, we operate within our previously established target leverage range of 0.9-1.25x, well below the regulatory limit of 2x, largely as a way to preserve our reinvestment option to create high risk-adjusted returns. This has been purposeful as we know that it is in periods of volatility and market dislocation that great investment opportunities are created while capital generally becomes constrained. Turning to liquidity, we think about our liquidity profile in terms of reserving for, 1, all near-term maturities, of which we have none. 2, unfunded commitments eligible to be drawn. 3, future pipeline investment opportunities, both known and unknown.

As of March 31, liquidity represented 3.2x the amount of unfunded commitments eligible to be drawn. Moving to our presentation materials. Slide eight contains this quarter's NAV bridge. Walking through the main drivers of NAV growth, we added $0.55 per share from adjusted net investment income against our base dividend of $0.46 per share. As Josh mentioned at the beginning of this call, there was $0.02 per share of accrued capital gains incentive fee expenses related to this quarter's net realized and unrealized gains. There was a $0.22 per share positive impact to NAV, primarily from the effect of tightening credit market spreads on the fair value of our portfolio.

Finally, other changes resulted in a $0.02 per share decline in NAV, which primarily included $0.08 per share from lower equity valuations, offset by $0.06 per share from realized gains. A large portion of the realized gains were driven by the payoff in February of our investment in WideOrbit. Moving on to our operating results detail on slide nine. Total investment income for the quarter was $96.5 million compared to $100.1 million in the prior quarter. Walking through the components of income, interest and dividend income was $92.2 million, up from $85.8 million in the prior quarter, driven by higher all-in yields and net funding activity.

Other fees representing prepayment fees and accelerated amortization of upfront fees from unscheduled pay downs were lower at $1.6 million compared to $11 million in Q4, given the minimal repayment activity we experienced in Q1. Other income was $2.8 million compared to $3.4 million in the prior quarter. Net expenses, excluding the impact of the non-cash accrual related to capital gains incentive fees were $51.4 million, up from $47.5 million in the prior quarter. This was primarily due to the upward movement in reference rates, which increased our weighted average interest rate on average debt outstanding from 5.4% to 6.7%, coupled with marginally higher average debt outstanding in Q1. Before passing it over to Josh, I wanted to circle back to our ROE metrics.

In Q1, we generated an annualized ROE based on adjusted net investment income of 13.3% and an annualized ROE based on adjusted net income of 16.3%. This compares to our target return on equity of 13%-13.2% for the full year as articulated during our Q4 earnings call. We maintain this outlook heading into the rest of 2023. With that, I'll turn it back to Josh for concluding remarks.

Joshua Easterly (CEO)

Thank you, Ian. I'd like to close our prepared remarks today by encouraging our shareholders of record to participate and vote in our upcoming annual and special meetings on May 25th. Consistent with previous years, we are seeking shareholder approval to issue shares below net asset value effective for the upcoming 12 months. To be clear, to date, we have never issued shares below net asset value under prior shareholder authorization granted to us for each of the past six years, and we have no current plans to do so. We merely view the authorization as an important tool for value creation and financial flexibility in periods of market volatility. As evidenced by the last nine plus years since our initial public offering, our bar for raising equity is high. We've only raised equity when trading above net asset value on a very disciplined basis.

We would only exercise the authorization to issue shares below net asset value if there are sufficiently high risk-adjusted return opportunities that would ultimately be accretive to our shareholders through over-earning our cost of capital in any associated dilution. If anyone has questions on this topic, please don't hesitate to reach out to us. We have also provided a presentation which walks through this analysis in the investor's resource section of our website. We hope you find this supplemental information helpful as a way of providing a clear rationale for providing the company with access to this important tool. As a final thought for today's call, we wanna address all the talk there has been about the current environment being the golden age for private credit.

While we believe that there is a huge opportunity for private credit and direct lenders in today's marketplace, we also believe there will be meaningful dispersion in returns for shareholders. To take advantage of the opportunities that requires a differentiated strategy, including the right human capital. It all starts with having the right team of people with expertise across sectors and industries who are positioned in the right seats to collaborate across a connected platform. We just returned from our annual Sixth Street offsite, where nearly our 500-person strong team gathers to work together and build relationships. This tradition continues to solidify the culture we've built and is essential to the success of our business in generating differentiated returns for our shareholders. With that, thank you for your time today. Operator, please open the line for questions.

Operator (participant)

Thank you. As a reminder, to ask a question, please press star one one on your telephone and wait for your name to be announced. To withdraw your question, please press star one one again. Please stand by while we compile the Q&A roster. Our first question comes from the line of Kevin Fultz from JMP Securities.

Kevin Fultz (Equity Research Analyst)

Hi, good morning, and thank you for taking my questions. With the recent turmoil in the banking sector, I was curious if you've seen any change over the past two months in your ability to negotiate better terms on the new deals that you're doing in the forms of more attractive spreads, lower LTVs, possibly lower leverage, or improved documentation. Just trying to get a sense if the deal-making environment has become even more compelling.

Joshua Easterly (CEO)

Kevin, thanks for the question. I would say on the margin, not. I think we haven't seen any step change from the regional bank failures. I'd say on the margin, quite frankly, to be honest, it's probably slightly more competitive over the last two months versus the previous two months before that. I would say, you know, it's pretty similar to the environment we've experienced over the last, you know, six, seven, eight months. There's been no kind of significant change on the margin given the regional banks.

Most of those regional banks did not play significantly excluding Silicon Valley Bank, Signature didn't play, FRB didn't play. We see super regional banks, but we don't see kind of the typical regional bank in our market in any event. On the margin, I would say not any step changes. Bo?

Bo Stanley (Partner and President)

Nothing to add there. I think, you know, on the margin, it's been slightly more competitive over the last couple of months, but still relatively attractive in historical terms. No step change since the regional banking crisis.

Kevin Fultz (Equity Research Analyst)

Okay, that all makes sense. Just one more from me. I'm curious if you saw an increase in amendment requests from borrowers in the first quarter, maybe also touching on what you're seeing quarter to date?

Joshua Easterly (CEO)

Yes, it's a great question. The answer is yes, but not mostly from LIBOR to SOFR amendments. Obviously, there's a big push given the discontinuation of LIBOR to get everybody onto SOFR. I would say when we look at our amendment activity, that the vast preponderance of those were just SOFR-LIBOR amendments and some upsizes. There was no significant kind of amendments due to underperformance.

Kevin Fultz (Equity Research Analyst)

Okay. That's good to hear. Congratulations on a really nice quarter. I'll leave it there.

Joshua Easterly (CEO)

Great. Thanks.

Bo Stanley (Partner and President)

Thanks, Kevin.

Operator (participant)

Thank you. One moment for our next question. Our next question comes from the line of Mark Hughes from Truist Securities.

Mark Hughes (Equity Research Analyst)

Yeah, thank you. Good morning. Did I hear properly? I think you said, within the portfolio, the revenue growth was 9%, EBITDA 17%. Is that correct?

Joshua Easterly (CEO)

Yeah. Let me take a chance to qualify. The way we think about it, that is the portfolio quarter-over-quarter. If you think about it on a static or same-store basis, it's a little bit smaller than that. It's year-over-year, 17%, and year-over-year, EBITDA growth of about 8%.

Mark Hughes (Equity Research Analyst)

Okay. Top line growing a little faster than EBITDA. That was gonna be my question?

Joshua Easterly (CEO)

Yeah. Yeah.

Mark Hughes (Equity Research Analyst)

Okay.

Joshua Easterly (CEO)

On a kind of like on a static basis.

Mark Hughes (Equity Research Analyst)

Yeah, understood. Any different industry mix in the pipeline? I think you said it started to build again in March. Any particular type of deal that's more likely to come to market in this kind of environment?

Joshua Easterly (CEO)

Yeah. Look, I would say for sure on the margin, our aperture as it relates to industries have opened up given the broad-based dislocation. For example, it's noted that we're involved in an aerospace and defense take private for a company called Maxar Technologies. That is a new sector to us, but a very large company, about $400 million-plus EBITDA. Healthcare for sure is an active space with a lot of assets coming to market. Given the broad-based dislocation, our sectors have opened up on the margin.

Mark Hughes (Equity Research Analyst)

Is there any change in your ability to take, kind of a leadership role where you've got effective control of these, you know, these, investments?

Joshua Easterly (CEO)

No, I would say, look, the larger ones are more club deals with like-minded investors where we hold a significant piece and we're typically the agent, or one of the agents or arrangers. So our access to diligence and, you know, is the same. I would say, you know, the larger deals are most definitely more clubbish. Thank you.

Operator (participant)

Thank you.

Mark Hughes (Equity Research Analyst)

Those are my three questions.

Operator (participant)

One moment for our next question. Our next question goes to the line of Jordan Wathen from Wells Fargo Securities LLC.

Jordan Wathen (Equity Research Associate)

Hi, good morning. There were a couple of deals that went to the public markets, after previously seeking private execution. Should we anticipate any fee, pickup for TSLX next quarter from those two deals?

Joshua Easterly (CEO)

Sorry, say that again, Jordan.

Jordan Wathen (Equity Research Associate)

Should we anticipate any break fees from some of the? There were deals that fell through that were gonna go private and then went syndicated. Should we anticipate that the BDC picks up any of the break fees?

Joshua Easterly (CEO)

Yes, it's a great question. You guys are perceptive. I think there's only one. I don't know if there's a couple, but there's one. That's Emerson. That credit, I think the public markets have opened up a little bit for higher quality credits. That ended up being a double B credit, you know, and a very large company and a double B credit. And there will be an alternative transaction fee that rolls through next quarter's income statement.

Jordan Wathen (Equity Research Associate)

Okay, great. Has there been any upward movement on floors, or is 1% still kind of the default number in private credit?

Joshua Easterly (CEO)

I would say, I think floors quarter-over-quarter is up slightly. I'll give you the exact data, but I think our floors are. Our average floor is 1%. I think slightly up quarter-over-quarter or flat quarter-over-quarter. They range between 75 basis points and 2%. For example, on Laramie was 2%.

Jordan Wathen (Equity Research Associate)

Okay, understood. Thanks so much.

Joshua Easterly (CEO)

Thanks.

Operator (participant)

Thank you. One moment for our next question. Our next question goes to the line of Erik Zwick from Hovde Group.

Erik Zwick (Director of Equity Research)

Good morning. wanted to start first and just thinking about the yield in the portfolio and the trajectory of investment income. It seems like the Fed is nearing the end of its hiking cycle. I think you also mentioned that, you know, spreads after widening for a while may be starting to tighten again. There's a little bit more competition in your markets there. just curious, are we potentially, you know, nearing the peak of the portfolio yield for this cycle? Or is there still opportunity as you're adding, as this, you know, kind of older loans are, you know, being repaid and you're adding new relationships where you can potentially get some wider spreads. As you mentioned, you know, the floors are slightly coming up.

Just trying to think about the kind of the puts and takes there and what that means for the trajectory of yield and income going forward.

Joshua Easterly (CEO)

Yeah. The way I would think about it is, look, the front end of the SOFR forward curve, or the SOFR curve is still relatively high out of the Fed funds rate. And I think there is a large debate in the marketplace where if the Fed, you know, has a near term cut, and I would take the under on a near term cut. That being said, if there is a near term cut, it's because there are those financial stability issues or recession fears, which I think would drive spreads wider in that moment of time and will recreate a good investment opportunity.

The way our income statement typically works is, or the core earnings of the business typically works is that when in an event where we have a tightening spread environment, we have much more activity-based fees that provide significant amount of near-term earnings to the book. In an event where spreads are stable or wider, obviously that is good for yields, and you know, good for total invested income lines, and portfolio leverage stays flat to increasing, which drives the ROE. I think in the near term, as you think about it, we remain in a, you know, a highly volatile environment, which either means that yields will remain stable or in the event that we are, the Fed is cutting, that spreads will widen.

I'm pretty bullish about the near term of kind of our business as it relates to the earnings profile and return on equity profile. The hedge again being activity-based income if spreads do tighten.

Erik Zwick (Director of Equity Research)

That's helpful. I appreciate it. The second one for me, just thinking about the funding profile. You're in a, you know, good position now where you don't have any notes coming due until the end of 2024 and still have quite a bit of capacity on your revolver. If we enter a period where we do go into maybe a moderate or potentially severe recession, and it seems like the banks are already pulling back a little bit on their funding, and if investors become a little bit more skittish, just curious how you think about, you know, funding your funding needs in a tighter environment from that perspective?

Joshua Easterly (CEO)

I think, I'll speak to this on a relative basis and an absolute basis. On an absolute basis, you hit it, which we don't have any near-term maturities until November of 2024. In the environment you called out, spreads are much wider on non-investment grade credit. Although we might have to pay for, our funding might get slightly more expensive, I would say that spreads are going to on our portfolio side because it's non-investment grade will be, I think, much better. I think we have this, you know, left-hand side of the balance sheet, non-investment grade issuers where we're always selective and have kept losses low.

The right-hand side of our balance sheet, we're an investment-grade issuer and the spread, kind of the beta on spreads is much higher on the asset side. I feel pretty good about our funding profile on an absolute basis. On a relative basis, I think we're much better positioned than the rest of the sector, which I think will benefit shareholders. Ian, do you have anything to add there?

Ian Simmonds (CFO)

No. I think you covered all of it, Josh. I think, you know, we're always mindful of keeping our options open and being opportunistic. We just keep a very careful eye on the market and then try to take advantage of windows when they present themselves to us.

Kevin Fultz (Equity Research Analyst)

Excellent. Thank you for taking my question today.

Ian Simmonds (CFO)

Thanks.

Operator (participant)

Thank you. One moment for our next question. Our next question comes from the line of Robert Dodd from Raymond James.

Robert Dodd (Director of Specialty Finance)

Hi, everybody, congratulations on the quarter. I'm just trying to get a handle on the potential on prepay activity, right? This is a question whether it's absolute or also whether it's relative to Q1, which was obviously quite light. I mean, in your, well then it's always volatile. In your prepared remarks, Josh, you did mention prepay fees potentially and potentially, upside to that 13.3. Bo mentioned some, you know, expect some opportunistic and idiosyncratic payoffs, and then also your fair value as a percentage core price ticked up this quarter. Is it fair to say that you expect prepay activity to probably ramp in the second half of the year?

Again, the question then is that ramp relative to Q1 or just, you know, ramp in total? Obviously, there's a Bed Bath & Beyond question as well. Any color you can give us on just thoughts?

Joshua Easterly (CEO)

Yeah. Let me give you the unamortized OID on Bed Bath & Beyond because so let's start with Bed Bath & Beyond. Bed Bath & Beyond we know for certainty is paying off.You know, we don't know the total net proceeds to us, as we discussed in the prepared remarks.

Robert Dodd (Director of Specialty Finance)

Mm-hmm.

Joshua Easterly (CEO)

That's why we don't have the call protection in the income statement and there's a valuation analysis on our balance sheet. We know that is paying off. I think there are three or four assets, three to four assets in our portfolio that are out to market today. Obviously, those are predominantly private companies, we have to respect their confidentiality. Who knows if those trade or not. I think one at least is going to trade. The pull-through on activity-based income is basically a function of what vintage they are and if there's call protection on unamortized OID.

I think on the unamortized OID for Bed Bath & Beyond was $1.4 million-$1.6 million, and then there is about $10.8 million of call of fees, capitalized yield maintenance fees that are above our par. It's, you know, I would say this continues to be a low point on activity-based. Obviously in an environment where spreads have widened, that is not shocking. We have a pretty good handle on how the model works, which is in a widening spread environment, activity fees go down, yields go up, leverage goes up, and you drive ROEs.

In an environment where spreads tighten, activity-based fees go down, leverage is harder to keep, financial leverage is harder to keep, and spreads may tighten, but it's offset by the activity-based. There are some names out there, and the obvious one is Bed Bath & Beyond.

Robert Dodd (Director of Specialty Finance)

Got it. Appreciate that color. The follow-up, and you partly answered it already, is how for lack of a better term, how onerous have you managed to make the call put on new deals in the sense that hypothetically if we don't have a bad recession, if the Fed stays up here for longer, which I think there's a meaningful probability of that. There's always the risk of spreads coming down relatively quickly, potentially, right? It's happened in previous cycles. How what's the risk of significant refinancing activity? You get the fees from it, clearly, right? The spreads compress potentially if a meaningful portion of the portfolio gets refied out, right?

There's always, to your point, there's a dynamic between fees and refinancing. How onerous currently is it for your portfolio to refinance relative to where you think something would it do you think it would meaningfully actually slow that activity, or could that happen quite quickly if spreads were to come down at some material-?

Joshua Easterly (CEO)

Yeah. Look, yeah. A couple of different things to parse because I think, one is I think we quote fair value as a percentage of call protection. That gives you some sense of how much embedded economics are in the book. There's a decent amount of embedded economics in the book.

Robert Dodd (Director of Specialty Finance)

Mm-hmm.

Joshua Easterly (CEO)

It's a function of, you know, I mean, the math for issuers is what's the payback period compared to the call protection, the economic payback period. It's a function of how spreads, how much do spreads tighten. If they tighten a little bit, it doesn't probably increase that much, you know, that much refinancing. If it tightens a lot, it probably does. That being said, I think there's a long history now. I think this is our 37th earnings call, and I don't know. I think I did that math last time in my head. When you look at our team's ability to create a differentiated portfolio across environments, it's pretty good.

That's a function that we have a large platform with that we get a large top of the funnel where we don't only do on-the-run stuff, but we do off-the-run stuff. This idea of, like, how much reinvestment risk are you taking, I think is mitigated by the scale of our platform as it relates to the capital we manage and our ability to find interesting things across cycles for our shareholders. You know, we've been through all these.

We've been through many cycles for the last 10 or 11 years with spreads widening and tightening. I think the average return on equity for the business is, like, 13%. We've always been able to have above average yields, and above average total return on assets and above average return on equity, which is a function of both finding interesting assets and having lower credit costs. I continue to be bullish across environment, and that's why we like the asset class, to view that across environments.

Robert Dodd (Director of Specialty Finance)

Got it. I appreciate that, though. Thank you.

Operator (participant)

Thank you. One moment for our next question. Our next question comes from the line of Ryan Lynch from KBW.

Ryan Lynch (Managing Director and Equity Research Analyst)

Hey, good morning. First question I had was, regarding just the potential for any sort of pullback in bank lending activity. I'm not really sure how much. It doesn't really seem like banks really compete with you all too much on kinda your LBO direct lending business. I was just curious, for the ABL portfolio, for the deals you guys have historically done, has that been a market that banks have played in historically? Obviously, you've won the deals, but are you competing with banks in any of those deals? Do you foresee any sort of pullback in that ABL sort of market from banks?

Joshua Easterly (CEO)

Yeah.

Ryan Lynch (Managing Director and Equity Research Analyst)

given this pullback?

Joshua Easterly (CEO)

Yeah. It's a great question. Let's start with the pullback for banks. I think that's most definitely happening. I think there's been a realization that banks had not completely understood their business model. Their business model is lending long and borrowing short through deposits. Those deposits they've been able to hold at very low costs. I think everybody's kind of woken up because of the kind of the big systemic issues of bank failures. The deposit beta is much higher than they thought, and they start moving things. Consumers and businesses started moving things to money market funds and treasuries and moving things out of deposits.

I think banks are going to pull back on lending until they understand what their capacity to lend in it is, given the balance sheet. On the, on the right-hand side, it feels very probably unstable to them. That's what caused banks to get closed out of their option. I think your general thesis is right, and I think, you know, people are starting to talk about a credit crunch, which I think is good for alternative lenders. Because our business models are distinct. I think when you think about where we competed with banks, you're right on the LBO business. Banks were not financing LBOs on their balance sheet directly. They were in the moving business, not the storage business.

Indirectly, they were financing LBOs in that they were buyers of triple As and investment grades and CLOs and supported capital formation in CLOs, which that capital formation allowed them to be in the moving business. I think CLO formation on the LBO side is, continues to be slow and slightly broken, with banks not participating in buying those securities given what's happened on their balance sheet. On where we competed directly with them on the storage business, there is small software companies for sure on banks which have cut capacity. We've seen Silicon Valley Bank obviously out of that business.

There's been some, you know, one or two SIFIs, not to be named, and a couple regional banks that have most definitely cut capacity in that space. On the ABL side, most definitely I would expect capacity to be cut in that space as well. I think that will most definitely create opportunity for kind of our, generally our specialty lending verticals.

Ryan Lynch (Managing Director and Equity Research Analyst)

Okay.

Joshua Easterly (CEO)

Is that helpful, Ryan?

Ryan Lynch (Managing Director and Equity Research Analyst)

Yeah.

Joshua Easterly (CEO)

I tried to do it in a linear way.

Ryan Lynch (Managing Director and Equity Research Analyst)

No. That's really helpful to just provide kind of an overall framework for where you guys kinda see the lending landscape for banks and how that affects you. The other question I had was, you have, you know, several different education software loans outstanding. I would just love to clarify. I've looked at those businesses. I believe most, if not all of those businesses are kind of in the kind of the management of the administration of schools and schooling software business. Can you confirm that? 'Cause obviously there's been some, you know, the actual software business that are providing education tools for students and those things that have come under a lot of stress in the public markets from, you know, some concerns about artificial intelligence.

I would love you to just talk about.

Joshua Easterly (CEO)

They're.

Ryan Lynch (Managing Director and Equity Research Analyst)

for business.

Joshua Easterly (CEO)

They're all ERP-like.

Bo Stanley (Partner and President)

Yeah. They all manage the back office of the schools themselves. We never got into the content part of that market. That was always harder for us.

Ryan Lynch (Managing Director and Equity Research Analyst)

Okay. Gotcha. All right. I appreciate the time today. Thank you.

Joshua Easterly (CEO)

Thanks.

Operator (participant)

Thank you. One moment for our next question. Our next question comes from the line of Melissa Wedel from J.P. Morgan.

Melissa Wedel (VP and Equities Research Analyst)

Good morning. Thanks for taking my questions today. Josh, you've made the comment a couple of times today that you're pretty bullish about the environment right now, and the opportunity for, I think, TSLX, but also, you know, private credit, generally. Given that you've taken leverage a bit higher this quarter, from last quarter, I'm curious, are you willing to take leverage, portfolio leverage up to sort of the top end of your range, given the bullish outlook? Or does the incremental sort of tighter spread, slightly more competitive environment, diminish that appetite at all?

Joshua Easterly (CEO)

No, I think we're still finding things to do. We're still picky and choosy. The range is the range, I think we're willing to take it up to the top end of the range. I would note that we slightly calculate our leverage on a conservative basis, which I think the market is net of cash and net of unamortized financing fees. If you look at it that way, I think we're slightly lower than what we've said. I think the, you know, we're willing to take it up. In addition to that support, you know, obviously Bed Bath & Beyond is coming off. Then we have a level two portfolio of about $50 million that provides incremental capacity as well. There's.

Paul mentioned there's a couple names in market. It feels like we have capacity, and it feels like the opportunity set, you know, still pretty good for us.

Melissa Wedel (VP and Equities Research Analyst)

Okay. Appreciate that. You also talked about potentially some healthcare assets in the market, that's something that you guys would be looking at. Could you provide any context within the healthcare sector? 'Cause that can be pretty diverse. Which areas do you find most appealing? Thanks.

Joshua Easterly (CEO)

Yeah. I mean, look, we've always had problems with services, given the cost structure and given the exposure to wage inflation. The assets we've looked at have not been in the services segment. Obviously we have a long history of doing biotech. There's been a whole host of healthcare assets, mostly actually not in the services space, that have come to market. Melissa, are you there?

Operator (participant)

Thank you. At this time, I would now like to turn the conference back over to Joshua Easterly for closing remarks.

Joshua Easterly (CEO)

Great. Well, thank you, Paul. Thank you for participating. Please remember to vote our shareholders in the annual special meeting. Obviously, Mother's Day is coming up, so, you know, be kind to all your mothers, and I most definitely appreciate my wife's. We'll see you in the summer and on our Q2 earnings call. Thanks.

Ryan Lynch (Managing Director and Equity Research Analyst)

Thanks, everyone.

Operator (participant)

This concludes.

Melissa Wedel (VP and Equities Research Analyst)

Bye

Operator (participant)

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