Sixth Street Specialty Lending, Inc.

Good morning and welcome to Sixth Street Specialty Lending, Inc., September 30, 2020, Quarterly Earnings Conference Call. Before we begin today's call, I would like to remind our listeners that remarks made during the call may contain forward-looking statements. Statements other than statements of historical facts made during this call may constitute forward-looking statements and are not guarantees of future performance or results and involve a number of risks and uncertainties. Actual results may differ materially from those in the forward-looking statements as a result of a number of factors, including those described from time to time in Sixth Street Specialty Lending, Inc., filings with the Securities and Exchange Commission. The company assumes no obligation to update any such forward-looking statements. Yesterday, after the market closed, The company issued its earnings press release for the third quarter ended September 30, 2020, and posted a presentation to the investor resources section of its website, www.sixstreetspecialtylending.com. The presentation should be reviewed in conjunction with the company's Form 10-Q filed yesterday with the SEC. Sixth Street Specialty Lending, Inc.'s earnings release is also available on the company's website under the investor resources section. Unless noted otherwise, all performance figures mentioned in today's prepared remarks are as of and for the third quarter ended September 30, 2020. As a reminder, this call is being recorded for replay purposes. I will now turn the call over to Joshua Easterly, Chief Executive Officer of Sixth Street Specialty Lending, Inc.

Thank you. Good morning, everyone, and thank you for joining us. We recognize that an ongoing pandemic continues to present very real and unique challenges for everyone and their families, so we're grateful to those who were able to join us today and thank all our stakeholders, wherever they are, for their continued interest and partnership. Once again, I'm here today with my partner and our president, Bo Stanley. and our CFO, Ian Simmons, both whom you'll hear from later on this call. After the market closed yesterday, we reported strong third quarter results with net investment income per share of 61 cents, over-earning our Q3 base dividend per share of 20 cents. Net income per share for the quarter was $1.21. These results correspond to an annualized return on equity on net investment income of 15.1% and a net income of 30.1%. On a year-to-date basis, we've generated an annualized return on equity on net investment income of 13.5% and net income of 14.7% based on a beginning year pro forma net asset value per share of $16.77, which is adjusted for the impact of our Q4 2019 supplemental dividend of $0.06 per share. Of note, these annualized year-to-date return ROEs both exceed our average annualized performance since our IPO through the end of 2019, which we think is notable given the difficult operating conditions experienced during the first three quarters of 2020. That said, based on market conditions today, we believe there are tail risks that all BDC portfolios are subject to, including credit risk and earning headwinds from LIBOR, which in our portfolio is offset by our LIBOR floors and the floating rate nature of our liabilities. Our strong net investment income this quarter was a function of both robust interest and fee income, as well as lower interest expense attributed to the 100% floating rate nature of our liability structure, which Ian will cover in more detail. This quarter's net income was supported by unrealized gains related to portfolio company specific events, spread-related unrealized gains from the continued tightening of credit risk premiums during Q3, and realized gains from the sale of our AFS equity position at a price that was significantly above our prior quarter's unrealized mark, which Beau will cover later on the call. This quarter's operating results contributed to the growth in our net asset value per share, which hit a record high of $16.87 at the end of Q3. This represents approximately a 5% increase from Q2 and a 1% increase from our 2019 year-end pro forma NAV per share of $16.77. If we were to add back the impact of the 50 cents per share of special dividends that were paid during Q2, we've grown net asset value per share by approximately 4% year to date. To reflect on this for a moment, in a year we've experienced tremendous market volatility and economic uncertainty, we've actually been able to grow net asset value per share while paying our highest level of dividends for the first three quarters of the year. This reinforces our belief that we've created a differentiated business model that not only survives but has the ability to outperform during periods of uncertainty. Notable drivers of net asset value growth year-to-date include 47 cents of over-earning against our base dividend, 23 cents of unrealized gains from the impact of effective wide workforce of 1.1% across our portfolio versus 36 basis points for the broadly syndicated loan market, 12 cents of net mark-to-market gains on our interest rate swaps primarily related to our 2022 and 2023 notes and 11 cents of net realized gains on investments. In the short periods of volatility across Q2 and Cross 3, we deployed approximately $150 million of capital across a combination of secondary investments and opportunistic financings. Through quarter end, these investments have generated $24.4 million of P&L, of which $9.7 million has been recognized in investment income. Therefore, post fees, we've generated to date $22.7 million of value or 34 cents per share solely through investments we made during the period of volatility earlier this year. Based on our net asset value rebound and the over-earning of our base dividend this quarter, our board declared a supplemental dividend in accordance with our formulaic dividend approach. A supplemental dividend of 10 cents per share, which is half of the quarter's over-earning, was declared yesterday to shareholders of record as of November 30th, payable on December 31st. Our board has also declared a fourth quarter base dividend per share of 41 cents to shareholders of record as of December 15th, payable on January 15th. Adjusted for the impact of the supplemental dividend related to this quarter's earnings, Q3 portfolio net asset value per share was $16.77. Now let me shift over to a brief update on our portfolio. The latest performance data continues to support our confidence in the overall health of our borrowers. While none of our portfolio companies have been immune to the economic impact of COVID, only 11% of our portfolio by fair value a quarter and has experienced meaningful performance issues directly related to it. We believe the relative resilience of our portfolios mostly a result of a deliberate shift we made in late 2014 towards a more defensive portfolio construction. Today, 95% of our portfolio by fair value is first lien and nearly 75% of our portfolio by fair value is comprised of mission-critical software businesses with sticky, predictable revenue characteristics. These businesses also tend to have variable cost structures, and it can be fluxed down to support debt service and protect liquidity in cases of challenging operating environments. The general nature of our portfolio, along with its first lien orientation, shorter weighted average life, and above-market LIBOR floors contribute to a lower beta characteristics to the benefit of our shareholders in times of market volatility. At quarter end, our debt portfolio had a weighted average fair value mark of 99. up three percentage points from its recent trough at the end of Q1, but below our pre-COVID levels of approximately par at the beginning of the year. Meanwhile, the leveraged loan index at quarter end had a weighted average bid price of approximately 95, up 11 percentage points from the end of March, and also below its pre-COVID levels of approximately 97 at the end of the year. As we've previously pointed out, the lower beta of our portfolio is due to a shorter weighted average life and higher LIBOR floors compared to the leveraged loan market. Note that the weighted average bid price for LCD first lien software names, like our portfolio, also experienced less volatility than the broader loan index during this period. While portfolios held up relatively well over the past couple of quarters, we'd like to reiterate that credit tail risks do exist in our portfolio, and more so today than pre-COVID. At quarter end, 12% of our portfolio had a fair value mark of less than 98 compared to only 8% of the portfolio in Q4 2019. The weighted average fair value mark for names in this tail at the quarter end was 88 compared to 96 at Q4 2019. Revisiting the concept of anti-fragility, The headwinds in our portfolio from credit year to date have been more than offset by the tailwinds from the value we've been able to create during the periods of market volatility across Q2 and Q3. There was a slight increase in our non-accruals this quarter from 40 basis points and 90 basis points on a fair value basis. This was primarily driven to the addition of First Lean Loan and MD America. and Upstream E&P Company, which is partially offset by removal of our pre-petition Neiman Marcus term loan and a partial roll-up of our JCP's pre-petition first lien term loan into the dip term loan. On MT America, we received a regularly scheduled cash interest payment during the quarter, but applied those proceeds to the amortized cost of our position, given our view of an imminent reorg of the company's capital structure that results in a reduction of the value of our loan. Post quarter end, the company made a voluntary pay down of $1.4 million on our position and subsequently filed for protection under Chapter 11 to implement its prepackaged plan of reorganization. For Q4, we expect to put $9 million of our loan or approximately 70% of our remaining prepetition loan at 930 fair value back on accrual status upon the company's emergence from Chapter 11. Our remaining investment will be structured in an equity position. Note that the quarter end, our total energy exposure was 2.4% of the portfolio fair value. With that, I'd like to turn the call over to Beau to walk you through our portfolio activity and metrics in more detail.

Thanks, Josh. During the third quarter, conditions continued to stabilize in the leveraged loan market as unprecedented levels of fiscal and monetary stimulus supported ongoing investor demand for risk assets. Secondary loan prices continued to recover in Q3. and primary issuance activity slowly reemerged in connection with opportunistic financing at M&A. On an absolute basis, however, leveraged loan activity in Q3 remained muted compared to historical levels, resulting in a 10-year low for year-to-date new issuance volumes. These trends carried across to the middle markets where overall activity remained modest. However, we noticed a notable increase in sponsor activity later in the quarter and into Q4. In contrast to the muted issuance activity in the loan markets, we had record Q3 originations activity with our highest level of commitment since inception at $436 million and our second highest level of fundings at $332 million. This activity was across 12 new and four existing portfolio companies. As alluded to on our last earnings call, despite the lack of middle market sponsor M&A since March, We had a very strong pipeline headed into Q3 given our diverse sourcing channels and deep sector relationships as part of our thematic investment approach. At a high level, this quarter's new investments were predominantly non-sponsored transactions where underwriting and sector capabilities, along with significant dry powder across the Sixth Street platform, allowed us to be value-add partners for companies and their management teams. Examples of this include the $500 million term loan facility that we underwrote with our affiliated funds for the publicly traded biopharmaceutical company Biohaven. Similar to our prior investments in Nectar and Ironwood, our Biohaven facility is secured by all assets of the company, including royalty streams from an FDA-approved drug, and therefore faces no underlying regulatory approval risk. In addition, certain delayed drop portions of our commitments are only available subject to the company meeting key revenue milestones. We've had historical success with our investments in the underlying theme and believe Biohaven continues to exemplify the strength and expertise of Sixth Street's healthcare franchise. Other new investments we originated this quarter include a $175 million ABL term loan for designer brands, of which we hold $50 million, and $125 million accounts receivable securitization facility for Centric Brands, both of which continue to exemplify our differentiated capabilities as solution providers in the consumer and retail sector. Post-quarter end, we fully exited our investment in Centric Brands in connection with a new financing obtained by the company as it emerged from bankruptcy. As Josh alluded to in his opening remarks, during our three-month hold period, we generated a P&L of $3.8 million on our investment represented a gross unlevered IRR of 31% on our capital invested. Other ways we created value during the short burst of volatility across Q2 and Q3 were through small opportunistic secondary market purchases in sectors or names that we know well. For example, we purchased $15 million par value of tech data syndicated by low term loan at 92 in July and completed the sale of our entire position post quarter end at a weighted average price of 98.4. Vertifor's first lean term loan was another liquid security that we purchased in late March at a price of $78.25 and sold during Q3 at a price of $99.8. Finally, the combination of our small BBB and BBB rated CLL purchases throughout Q2 and Q3 have to date resulted in nearly half a million dollars of P&L for our portfolio. Though not one of our primary investment themes, these opportunistic secondary market purchases continue to be an and David Stiepleman. The Q3 was also active for us on the repayment side, with $253 million of repayments across eight full and five partial realizations, and the combination of a funding and repayment activity during the quarter resulted in net fundings of $79 million. The bulk of this quarter's repayments were driven by three investments, our $72 million Neiman ABL Philo upon the upon the company's reemergence from bankruptcy, our $51 million Diane Durham first lien loan in connection with the company's IPO, and our $45 million AFS first lien loan and equity positions in connection with the sale of the company to a strategic buyer. Some of you may recognize AFS as one of our longest-standing portfolio companies, with our first investment dating back to 2011. Since the original investment, we've supported the company through various transitions and ownership changes including the sale of our majority equity ownership stake to the sponsor in 2018. We believe AFS is an example of our asset management capabilities along with our flexible capital base allow us to be long-term value-added partners for management teams and sponsors. For our shareholders, our equity position in AFS was fully realized this quarter at a value of $16.2 million compared to our prior quarter's fair value mark of $7.3 million. Moving now to portfolio yields, the weighted average total yield in our debt and income-producing securities at amortized cost increased by approximately 20 basis points to 10.2% this quarter, primarily driven by the favorable impact of this quarter's funding activity. The yield at amortized cost of new investments in Q3 was 11.5% compared to 10.8% for exited investments. Note that LIBOR movement during Q3 had minimal impact on this quarter's portfolio yield given that LIBOR had already fallen below the effective average LIBOR floor across our portfolio in the prior quarter. Now a brief update on our portfolio composition and credit stats. Our top two industry exposures continue to be stable, led by business services at 22.9% of portfolio at fair value, followed by financial services at 16%. and more. Retail and consumer products was our third highest industry exposure, increasing from 11.3% to 13.9% quarter over quarter. This was primarily driven by new fundings for designer brands and centric brands, which was partially offset by the repayment of the Neiman ABL Filo Term Loan. Pro forma the pay down of centric brands, our retail and consumer exposure would have been 10.5% at quarter end, and retail names with retail names comprising 9.5% of the portfolio and 77% of this exposure consisting of ABL investments. In September, upon the full repayment of the Neiman ABL, Philo, and Dip loans, we subsequently funded a new $17 million par value first lien loan related to our exit financing backstop commitment. In our schedule of investments, the roughly $4 million difference between the par value and the cost basis of the new Neiman loan reflects our fees on the backstop which were payable in common stock of the reworked company. Our loan today is trading at a price of approximately 104.75. This, again, was another way that we created value during the volatile market environment earlier this year. We believe our attractive cost base along with the company's high-quality assets and improved prospective cash flow profile post-restruction provide considerable downside protection on our investments. As Josh discussed earlier, the overall performance of our portfolio continues to remain relatively resilient, which is a testament to our team's deep knowledge of the industries where we are active and our close relationships with our portfolio company and management teams. Our portfolio weighted average performance rating was 1.21 compared to 1.23 in Q2 on a scale of 1 to 5, with 1 being the strongest. There were no material changes in the overall credit metrics of our portfolio companies. Interest coverage this quarter remained flat at 3.3x. Net attachment point was unchanged at 0.4x. And net leverage increased slightly from 4.3x to 4.4x, which is on par with our trailing two-year historical quarterly average. The weighted average annual revenue and EBIT of our core portfolio companies increased slightly this quarter to $117 million and $36 million, given our migration towards larger borrowers, as well as the organic growth of certain existing borrowers. While the path of this economic recovery remains highly uncertain, based on our close engagement with our borrowers, we don't expect any material deteriorations in the overall performance of our portfolio in the near term. With that, I'd like to turn it over to Ian.