Sixth Street Specialty Lending - Q2 2024

Transcript

Operator (participant)

Good morning and welcome to Sixth Street Specialty Lending, Inc.'s Second Quarter Ended June 30th, 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 1st, 2024. I'll now turn the call over to Ms. Cami VanHorn, Head of Investor Relations.

Cami Van Horn (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 30th, 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 30th, 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.

Joshua Easterly (CEO)

Thank you, Cami. Good morning, everyone, and thank you for joining us. With us is our President, Bo Stanley, and our CFO, Ian Simmonds. For the call today, I will provide highlights of this quarter's results and then pass it over to Bo to discuss activity and 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 unwind of the non-cash accrued capital gains incentive fee expense, were both $0.01 per share higher.

At June 30th, our net asset value per share reached a new all-time high of $17.19, representing an increase of 2.7% year-over-year and an annualized growth of 3.4% since inception, part of the impact of special and supplemental dividends we've distributed over that time. We don't want to sound like a broken record, but our outlook for the 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 bottoms 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 and potential for credit losses. We started to see this play 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 tails 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 that we are 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 to exceed it. Given the rapid change in the spread environment and private credit, there's one key question operators should be asking themselves, which is, what is the required spread on investments to earn my cost of equity? This is a framework that guides us to maintain 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 is below the industry's cost of equity. We acknowledge that pricing floor exists in the BDC model, and capital should not be allocated to investments below a certain spread.

We'll walk through this in detail now to clearly demonstrate that operating a successful BDC is about discipline and capital allocation. We'll start with the assumption that the average cost of equity for a publicly traded BDC is 9.4%. This is based on the data sourced from Bloomberg across our peer set, which incorporates the 10-year treasury rate. 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 and 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 SOFR swap rate of approximately 4%, 1.5% OID over a three-year average life, the required portfolio spread to earn a 9.4% cost of equity is approximately 620 basis points over SOFR.

It is important to note that this output reflects leverage at the top end of the range indicated by rating agencies to be designated Investment Grade and is before the impact of credit losses. Historically, annual credit losses have averaged approximately 100-130 basis points on assets according to Cliffwater Direct Lending Index. Including credit losses based on this data, the required spread applying our Cost of Equity assumption is 750-780 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 is 6.3% and 3.4%-4% after losses. At these spreads, the sector is not earning its current dividend yield, let alone its Cost of Equity.

While we acknowledge this must be viewed on a portfolio basis, we outline the math to be illustrative yet instructive 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 than the long-term industry average. Taking a look at our portfolio, the weighted average spread on new investments this quarter was 6.6%. If we apply a spread of 650 basis points to our unit economics model, including activity-based fees on a three-year historical average, leverage at 1.2x, and credit losses between 0 and 50 basis points, the output is 11%-12% return on equity. Again, this math is based on the weighted average of one quarter's new investments, which compares to a weighted average spread with a portfolio at fair value of 8%.

This clearly indicates that we are continuing to overrun our cost of equity. Our track record of generating a 13.5% annualized ROE on net income since our IPO in 2014 further demonstrates this 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 is $1,713. We estimate that our spillover income per share is approximately $1.15. With that, I'll pass it over to Bo to discuss this quarter's investment activity.

Bo Stanley (President)

Thanks, Josh. I'd like to start by sharing some observations on the broader macroeconomic environment and how that's impacting deal activity in the private credit markets. Over the last few weeks, the U.S. economy has started to show signs of softness, evidenced by an increase in unemployment claims and 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 the historically low levels experienced over the past two years. While not yet back to the pre-rate hike levels, green shoots in the deal environment contribute 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 continue to benefit from the size and scale of Sixth Street's 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 or lower deal activity. As a result of our wide originations funnel, we continue to source new investment opportunities this quarter with 83% of total fundings in new portfolio companies. To highlight our largest funding this quarter, we agented and closed 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 relationship positions us well to be a solutions provider for companies like Merit.

Through our connectivity across the Sixth Street platform, we have multiple touch points with the company from inception of the business to when 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 experienced $290 million of repayments from 6 full, 4 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 rebuys in the private credit market, and one refinancing to a bank loan.

We also experienced a payoff in our Retail ABL III, 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 earned $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 differentiates our portfolio relative to the sector and creates 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, ReliQuest 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 99 Cents Only. 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 through several amendments, maturity extensions, and restructurings, ultimately resulting in the company filing 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 a 55.7% IRR on the DIP term loan. While this opportunity set ebbs and flows, we've seen an increase 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 upsizes for Q2, was 12.5% compared to a yield of 14.1% on fully exited investments. To provide some color on the investment portfolio today, credit quality remained 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 1 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 stats, across our core borrowers for whom these metrics are relevant, we continue to have conservative weighted average attach and detach points of 0.6x and 5.0x, respectively, and our weighted average interest coverage increased slightly from 2.0x to 2.1x quarter-over-quarter.

As a reminder, interest coverage assumes we apply reference rates at the end of the quarter to steady-state borrow EBITDA. As of Q2 2024, the weighted average revenue in EBITDA of our core portfolio companies was $310.4 million and $104.4 million, respectively. There were no new investments added to non-acccrual 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.

Ian Simmonds (CFO)

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 were $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 revolving capacity at quarter end against $250 million of unfunded portfolio company 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 revolving 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 revolving capacity to reach the top end of our target leverage range of 1.25x debt-to-equity and further draw down 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 overallotment 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 detail 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 paydown, were higher at $4 million compared to $1.5 million in Q1, driven by increased activity-based 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 a penny per share quarterly in 2025, as the implied funding mix shift will lower our weighted average 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-$2.41, corresponding to a return on equity of 13.4%-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.

Joshua Easterly (CEO)

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 with 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, investing in a platform that has a wide origination funnel. Despite the competitive direct lending backdrop that exists today, we have remained active, yet selective because of the benefits of the Sixth Street Platform. This wide range of deal flow allows us to make calls on relative value, toggle between large, cap, and middle market exposure, weigh in the sector themes, and most importantly, pass on investments that do not meet the risk return and absolute return profiles we target for our shareholders. As disciplined investors, we make these choices with shareholder returns top of mind, which we believe leads to better credit selection and ultimately translates to a lower credit loss over the long term and better shareholder experience. With that, thank you for your time today. Operator, please open the line for questions.

Operator (participant)

Thank you. At this time, as mentioned, we'll now conduct the question-and-answer session. To ask a question, you'll need to press star 11 on your telephone and wait for your name to be announced. To withdraw your question, press star 11 again. Please stand by while we compile our question-and-answer roster. Our first question comes from the line of Finian O'Shea with WFS. Your line is now open.

Speaker 5

Hey, everyone. Good morning. Taking some of the opening comments on the market, there's a rapid change in private credit you noted, assuming that references the amount of capital that's been raised and so forth, and then how you're passing on a lot of deals due to yield, the cost of capital. Would you say this relates to the deals you're passing on? Does it relate to market deterioration and credit underwriting, or are there more firms out there that can do complexity at scale?

Joshua Easterly (CEO)

Hey, Finn. 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 it's not really credit deterioration or credit underwriting deterioration, even in those deals. It's just that the sector, BDC specifically, given where they borrow, the amount of capital they have to hold, i.e., they can only be 1.25x leverage, and fees and expenses, all that good stuff, puts them at a place in the cost curve where 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—we talked about our spreads for this quarter, which is predominantly sponsor stuff, which was, I think, above the sector and above our earning our cost of equity. If you look at what we funded quarter to date, it's 20-30 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 the pipeline, it's like 8.60 spread, and that's before fees, and that's predominantly non-sponsored stuff. So I think it's mostly in the sponsor stuff. And again, I think the relationship of the size of your origination platform, your capabilities compared to the size of your capital are really, really important in being able to continue to create shareholder value.

Speaker 5

That's very helpful. Thank you. A follow-up on Europe that seemed 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 in the market?

Joshua Easterly (CEO)

Yeah. Yeah. So look, I would say when you look at Europe, I think you're referring to by number, but probably not necessarily by dollar amount. So by dollar amount, I don't think that's a true statement. By number, that is a true statement. Under the exemptive relief, our strategy is we want to make sure Sixth has the ability to continue to invest in deals, and so it needs to take a position day one in 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. It's 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 sponsor stuff is better in Europe than it is in the U.S. I think, Bo, you would agree with me on that.

Bo Stanley (President)

Yes, for sure.

Joshua Easterly (CEO)

But again, I think it's by number, not by dollar. By dollar, it's predominantly U.S. Still, we like the risk return. For example, one of the larger things we did was Adevinta, which was a buyout of kind of the eBay auction assets in Europe, and that has a nice spread compared to what you can find in the U.S.

Speaker 5

Thanks so much.

Joshua Easterly (CEO)

Thanks, Finn. Have a good day.

Operator (participant)

Thank you. Our next question comes from Brian McKenna with Citizens JMP. Your line is now open.

Speaker 5

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?

Joshua Easterly (CEO)

Yeah. Hey, Brian. So I would frame it so 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 were able to raise that. We had a convert, and I think we did two equity raises, Ian?

Ian Simmonds (CFO)

Three of them.

Joshua Easterly (CEO)

Three. So it's really that it wasn't the portfolio rotation or the portfolio composition changed, not because of turnover. Turnover has been light post-rate hiking cycle. You can see that in it's starting to pick up, but you can see that actually in the activity-based fees. I think going forward, if the Fed pivots, which it feels like they set that up to pivot in September, deal activity picks up, spreads have already started to come in, but deal activity picks up. My guess is there will be more natural kind of turnover in the portfolio, which will, from an economic basis in the short term, our shareholders will benefit from because activity-based fees will pick up. And you saw those activity-based fees pick up.

This was the first quarter we had a little bit of net repayments, and activity-based fees picked up this quarter slightly in line with that.

Speaker 5

Okay. Helpful. Thanks. Then just a bigger question here, Josh. It would be great just to get your thoughts on the broader macro. Clearly, there's a lot of puts and takes looking out over the next year. Longer-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?

Joshua Easterly (CEO)

Yeah. So it's a tricky environment. I actually am pretty bullish about the vintages of today. Those vintages are based on or underwritten in a higher rate environment where you haven't had the tailwind of the Fed cutting rate and the stimulus of demand that comes with a rate cut. So you got to be bullish on the last couple of years' vintages 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, I think, 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 GAAP ROEs, so the difference between NII and NI. And you see that a little bit. I think you'll see that continue a little bit. So, but I mean the economy is most definitely softening, 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 the consumer, especially the lower end, that will be pinch points and pain points. And then, obviously, the geopolitical, who knows?

Speaker 5

Yep. Got it. All right. Great. Thanks. I'll leave it there. Appreciate it.

Joshua Easterly (CEO)

Thanks.

Speaker 5

Thanks.

Joshua Easterly (CEO)

Have a great day.

Operator (participant)

Thank you. Our next question comes from the line of Mark Hughes with Truist Securities. Your line is now open, Mark.

Speaker 5

Yeah. Thank you. Good morning. You're integrated on the deal flow. Good morning. Has that changed materially over the last six months? Just if you're having to be more selective, how is that working out in terms of your success rate?

Joshua Easterly (CEO)

Yeah. 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 the things we do today will generate the return on equity for 2025 and 2026. And even though that we have a backbook with a higher yield, we want to be cognizant of making sure we earn our return on equity. So I think our hit rate's similar, except that there are things that we like the credits. We just don't like the prices.

Speaker 5

Yeah. Yeah. The average commitment, this may be just an unfair snapshot, but the average commitment was a little lower in 2Q, say, compared to 4Q. Are you seeing more opportunity at the smaller end of the market?

Joshua Easterly (CEO)

No. I mean, no, that's a reflection of the co-investment strategy where in European deals or large-cap deals, Sixth or European deals is taking a smaller position. And so there's a whole bunch of, on the European deals, like $5-$6 million that are dragging it down. But if you look at the core positions like Merit, Adevinta, those are kind of $35-$40 million commitments. So it's a little bit more of that just participation in how the co-investment, the new co-investment order reads.

Speaker 5

Yeah. I think you mentioned the word toeholds. And then final question.

Joshua Easterly (CEO)

Yeah.

Speaker 5

You described how 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?

Joshua Easterly (CEO)

I mean, the great thing about being part of, as people know, Sixth Street's an $80 billion platform and having this wide aperture that we get to toggle between things. So we did this quarter non-sponsor. We did Apellis, which was a SpecPharma deal. We liked that space. I think there's probably more to come. We did a Retail ABL financing, the consumer's weekend. That space needs our capital again. And that was done post-quarter end, which is a non-sponsor deal. So we kind of the great news is having a big wide top of the funnel is we get to be picky and choosy and making sure we're driving shareholder return.

Speaker 5

Okay. Appreciate it. Thank you.

Joshua Easterly (CEO)

Thanks. Have a great day.

Speaker 5

You too.

Operator (participant)

Thank you. Our next question comes from the line of Mickey Schleien with Ladenburg Thalmann. Your line is now open.

Speaker 6

Yes. Good morning, everyone. Josh, not to beat a dead horse here, but I wanted to ask you a follow-up question on spreads. Do you think it's just this issue of a massive supply of private debt capital that's 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?

Joshua Easterly (CEO)

My sense is 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 the last one or two or any calls. So it's good to hear your voice. You always have very good questions. My sense is that 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 to an equilibrium here shortly with the Fed cutting and more M&A picking up. But we were kind of in this the supply kind of outpaced demand early on, and we've always wanted to be very disciplined.

Then the incentives for managers to put that to work and earn fees, etc., those are real incentives. We've always tried to fight those and A, acknowledge those incentives and B, fight those incentives and think about the long term of shareholder experience. My hope is that with more demand coming from a loosening environment that will drive an M&A and will drive investment in CapEx and growth, that the supply and demand kind of will get more in balance.

Speaker 5

That's good to hear. And if I could follow up, Josh, with this sort of disintermediation of the commercial banks that's occurred over the last many years and the rise of private credit, 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?

Joshua Easterly (CEO)

Yeah. Look, I have a whole thing about this. The systemic risk point is a little bit silly. And I think the first thing I would say is that unlike the banking system, the taxpayers haven't written a put for private credit. And the systemic risk really comes from a little bit of that some of that put obligation for taxpayers and that the Fed has effectively, through the FDIC program, backstopped asset choices for banks. The second thing is most systemic risk has come from an ALM issue, which is that people are long assets and short liabilities, and that does not exist in private credit. And private credit's match-funded. There's no ALM. We talk about this often, but I think the average life of our assets funded with leverage is like two and a half years 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 BDCs, specifically in private credit, as compared to banks, hold somewhere between 3 and 5 times the amount of capital of banks. And so risk-bearing capital on BDCs are about 45%-50%. You think about 1x leverage or 1.1x leverage. And banks, they hold about 8% capital. And so the idea that there is real systemic risk or real risk of loss to 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 hold 8% capital, you lend 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 and 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?

Speaker 6

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 Khoros, 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.

Joshua Easterly (CEO)

Yeah. Lithium is purely idiosyncratic. So it probably been in the one thing I would be critical on the margin of us in the 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 was leveraging engagement online and through social media platforms. That was probably a positive tailwind that's unwound. So it's purely idiosyncratic.

Speaker 6

Okay. I appreciate that. That's all for me this morning. Thank you for taking my questions.

Joshua Easterly (CEO)

Thanks, Mickey.

Operator (participant)

Thank you. Our next question comes from the line of Kenneth Lee with RBC. Your line is now open.

Speaker 7

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 tightening across the industry. 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.

Joshua Easterly (CEO)

Look, I would say documents have been pretty stable. So I think underwriting standards remain good in private credit. I mean, the question again is, where are we sitting on the cost curve? What's the required spread to earn 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 backbook. But the things you do today are the ROEs in 2025 and 2026. But the weighted average financial covenants and all that stuff is basically the same. And the docs are in pretty good shape.

Speaker 7

That's right.

Great. Very helpful there. 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 more of a macro slowdown before you start seeing more opportunities there? Or could we see a potential pickup in more complex investment opportunities when M&A activity rebounds as well? Thanks.

Joshua Easterly (CEO)

Yeah. Look, 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 got allocated very poorly. The complexity is going to come from that pipeline of yesterday's mistakes. And that's going to be there no matter what. Then I think the also tailwind is if M&A picks up, people will some of our competitors or a lot of our competitors, quite frankly, that stuff is easier to pursue with less people. And so their eyes will go that way. And so I think you have two kind of compounding effects, 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 gaze will be focused on that.

I think I'm pretty bullish about the next couple of years for our complexity theme.

Speaker 7

Great. Very helpful. Thanks again.

Operator (participant)

Thank you. Our next question comes to the line of Paul Johnson with KBW. Your line is now open.

Speaker 8

Good morning. Thanks for taking my questions. So just with the development of liability management exercises and development of recently Pluralsight, realizing obviously Pluralsight's not in your portfolio, but I'm just wondering your thoughts on whether those types of events increase the risk of sponsor concentration issues where if you have an adverse event with one of your common partnering sponsors, there's risk to the deal flow, as well as just kind of the calculus of working within lender groups as well?

Joshua Easterly (CEO)

Yeah. So look, I don't really have anything to add in Pluralsight. We're not that involved. We were not involved. Not that we're not that involved. We weren't involved. So I can't add anything specific. I would say my understanding of that situation is that doc seemed like it was a doc that was kind of slightly outside of the range of the existing docs, or at least the docs in our portfolio, as I understand it. And the good thing is that it wasn't done. There was no lender-on-lender violence that existed, like you see in the broadly syndicated loan market, where there's this prisoner's dilemma, which is, "I got to do it because if I don't do it, somebody else will do it." And that didn't exist.

And then you're also seeing, so I think that I don't see that as a big. I think that's an overblown concern in private credit. On the sponsor concentration, which I'm not sure they're exactly related, we don't really have sponsor concentration. Historically, we've done about 65% sponsor stuff, 35% non-sponsor in existing book today. We have no sponsor above 10%. And we have like 45 or 50 sponsors in our book. So I'm not. I don't see them related. But I think I answered your question if that's helpful.

Speaker 8

Yeah. That's very helpful. I appreciate that. I mean, do you think that an event like that is just the result of bad credit underlying bad documentation, or is this lawyers that are basically at fault here?

Joshua Easterly (CEO)

I would never blame look, I can't really speak to. I don't want to speak to Pluralsight. I'm not involved. So I don't have the things are going to happen in our business. We've been very good on the credit side and stuff pops up still. So things are going to happen. Part of our business is a little bit about or a lot of our business, the only thing about our business is about figuring out what the future looks like and trying to use historical and industry structures as an analog for that. And so we're in underwriting the future because value is based on future cash flows and how the business performs future. And on the margin, sometimes you're going to get it wrong. And so I think that's important as it relates to industry selection and where you invest in the capital structure.

But I can't speak to Pluralsight specifically.

Speaker 8

Got it. Appreciate that. Yeah. I was just kind of asking a little bit more broadly on the space, but appreciate the answers and your thoughts on the good question.

Joshua Easterly (CEO)

Yeah. Thanks. Look, I would never blame something on a service provider. So we're principals. We own our decisions. So lawyers can't. It's tough to blame on lawyers. They're service providers. We're principals. And so we're in there if it's a mistake, I own it. We own it as a team.

Operator (participant)

Thank you. Our next question comes to the line of Melissa Wedel with J.P. Morgan. Your line is now open.

Speaker 9

Good morning. Thanks for taking my questions. Most of mine have actually been asked already. Quick clarification. When you talked about the pipeline, kind of going forward, did I miss it, or did you size that at all for us?

Joshua Easterly (CEO)

Yeah. So I'll hit it real quick. Look, you missed it. It's probably the near-term stuff is $200 million in that in this next kind of quarter, I think, if that's helpful. On the growth side before repayments.

Speaker 9

Yep. Got it. I appreciate that. And then separately, kind of digging into the non-sponsor side a little bit. When we hear non-sponsor, I tend to think those 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, does that take longer for your team to sort of diligence and close? Do those investments, is the timeline any different for you versus some of the larger, more maybe syndicated across a few lender-type deals, sponsored deals?

Joshua Easterly (CEO)

Yeah. Yeah. So I would say the barrier to entry for why I think we see less competition is for the manager is a much more difficult, less profitable business. It takes longer. It takes more resources. It takes more time both on the underwriting side, on the asset management side. And so it is and 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 I think that's why historically you need specialized resources. It's people-intensive. The example I give to people is on the ABL stuff.

The ABL stuff, the average life is everybody understands the fees in our business, but if you could earn X fees on something that has an average life of 3 years, and it's a lot easier to prosecute than earning the same fees on something that has an average life of 1.5 years, and it's a lot harder to prosecute. It's not shocking what people do. But not smaller. Actually, sometimes bigger. Yeah. A lot of times bigger.

Speaker 9

Interesting. And.

The only thing we'd add is that these are not necessarily smaller opportunities. These are large businesses generally.

Got it. And is the use of funds what, strategic M&A or other?

Joshua Easterly (CEO)

No. Sometimes it's balance sheet restructuring. Sometimes it's exiting of a bankruptcy. Sometimes it's entering a bankruptcy in a DIP. Sometimes it's a bridge to somewhere, but they don't know exactly where somewhere is because they have an overlevered balance sheet like Ferrellgas. They don't really know when we did that deal where they had an overlevered balance sheet. We were the senior secured. They don't know exactly where it was going. So it's a whole host of things. And our Spec Pharma, it's R&D. It's R&D development and our Spec Pharma stuff. That's right.

Speaker 9

Appreciate it. Thank you.

Operator (participant)

Thank you. Our next question comes to the line of Bryce Rowe with B. Riley. Your line is now open.

Speaker 10

Thanks a lot. Good morning. Maybe wanted to offer one follow-up to Melissa's first question there. Helpful for you all to kind of size up the portfolio in terms of the gross potential, at least over the near term. 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?

Joshua Easterly (CEO)

Yeah. I think our base cases were kind of net flattish, Ian. Is that?

Ian Simmonds (CFO)

Right.

Joshua Easterly (CEO)

So gross originations will pick up as activity levels pick up. Repayments will, which will create economics in the book. But I think it's net flattish, which we think is good. I would like to have being kind of 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.

Speaker 10

Yeah. Okay.

Joshua Easterly (CEO)

Without having to do equity.

Speaker 10

That's helpful, Josh. I appreciate it. Maybe a question around some of I think it was Bo 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.

Joshua Easterly (CEO)

Yeah. Look, I don't see a real 2001, 2008 credit cycle. I just don't see that. But I do think you'll have elevated tails. Businesses have performed relatively well. The portfolio 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 cycle. But I do see that when you take a step back, that capital pre-COVID, post-COVID was misallocated, which has created the tails where you had basically 0%-1% interest rates for a long period of time. And so there has to be a reckoning to some of that misallocation 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's actually found a pretty decent balance. Okay. Great. I appreciate the perspective. Everybody likes to be critical.

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.

Speaker 10

Got it. Got it. Thank you.

Operator (participant)

Thank you. Our next question, which is our last question, comes to the line of Robert Dodd with Raymond James. Your line is now open.

Speaker 11

Thank you. Morning. Bryce actually just asked the same question. So about growth. So kind of a little add-on to that. I mean, if you kind of flatten 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 this size?

Joshua Easterly (CEO)

Yeah. It's a good question. For us, it's really how we let me tell you philosophically how we set up our business because the answer is I don't know. And if I sit here telling 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 those fill the top of the funnel.

And as allocators of capital, we get to say, "Where does it overlap where they're really good risk return on an unlevered basis and where they provide significant shareholder value and meet the return on equity requirements of our shareholders?" And so we really like that model because that model allows us to drive. We've been a public company now for 10+ years, and we've been able to, I think it feels longer, to be honest with you, 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 in the cost curve and our return on equity. That, to me, is the formula. Now, do I know exactly what options are going to be in the money in the top of the funnel?

I don't know.

Speaker 11

Fair enough. Thank you.

Joshua Easterly (CEO)

Awesome. It's good to hear your voice, Robert.

Speaker 11

Thanks.

Operator (participant)

Thank you. I'm showing no further questions at this time. I would now like to turn the call back to Josh Easterly for closing remarks.

Joshua Easterly (CEO)

Great. Well, look, we really appreciate everybody's thoughtful and engaging questions. I hope everybody has a great end of the summer with their families. 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.

Operator (participant)

Thank you. This does conclude the program, and you may now disconnect.

Goodbye.