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spk08: Good morning and welcome to the 6th Street Specialty Lending Incorporated. First quarter ended March 31st, 2021 earnings conference call. Before we begin today's call, I would like to remind our listeners that remarks made during this 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's incorporated filings with the Security 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 first quarter ended March 31, 2021, and posted a presentation to the investor resource section of its website, www.sixthstreetspecialtylending.com. The presentation should be reviewed in conjunction with the company's form 10-Q filed yesterday with the SEC. Sixth Street Specialty Lending Incorporated's earnings release is also available on the company's website under the investor resource section, Unless noted otherwise, all performance figures mentioned in today's prepared remarks are as of and for the first quarter ended March 31st, 2021. 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.
spk02: Thank you. Good morning, everyone, and thank you for joining us. With me today is my partner and our president, Bo Stanley, and our CFO, Ian Simmons. I hope that everyone is well. For our call today, I will provide highlights for this quarter's results and then pass it over to Bo to discuss this quarter's origination activity and portfolio metrics. Ian will review our quarterly financial results in more detail, and I will conclude with final remarks before opening the call to Q&A. After market closed yesterday, we reported strong first quarter financial results with adjusted net investment income per share of 53 cents, corresponding to an annualized return on equity of 13.3 percent, and adjusted net income per share of 88 cents, corresponding to an annualized return on equity of 22.1 percent. This quarter, we continue to accrue capital gains incentive fee expense related to changes in net realized and unrealized gains and losses. This non-cash expense, which was not paid or is not payable, was approximately $0.07 per share for the quarter. Our Q1 net investment income and net income per share, inclusive of the accrued capital gains and fee expense, was $0.46 and $0.81, respectively. Pausing on the impact of these adjustments for a moment, as an illustration, if we were to end the year as of March 31st, the $0.08 per share of cumulative accrued capital gains incentive fee expenses that we had at quarter end would not be paid or payable since the gains must be realized in order for us to be eligible to receive these fees. In addition, it's also worth noting that a portion of these unrealized gains today are related to the impact of call protection on the valuation of our debt investments, which, if realized, would ultimately flow through net investment income and, therefore, trigger a reversal of associated crude capital gains and fee expenses. Now back to our results. Our strong net investment income this quarter continues to be a function robust net interest margin attributable to our floating rate liability structure in this low rate environment in connection with liable floors on our debt investments. Net investment income was also supported by higher interest and dividend income from an increase in the average size of our portfolio as well as fee income from portfolio prepayment activity. The difference between this quarter's net investment income and net income was a result of net realized and unrealized gains, primarily from the small portion of our portfolio represented by equity investments, as well as net unrealized gains from the impact of credit spread tightening on the valuation of our debt investments. At quarter end, net asset value per share was $16.47, up 3.8% from pro forma net asset value per share at year-end of 1586 that we discussed on our last earnings call. As mentioned, net realized and unrealized gains from our investments were meaningful contributors to this quarter's net asset value per share growth. Other contributors included accretion from our follow-on equity raise in February and the continued overrunning of our base dividends. Ian will discuss our net asset value bridge in more detail later on this call. Yesterday, our board approved a base quarterly dividend of 41 cents per share to shareholders of record as of June 15th, payable on July 15th. Our board also declared a supplemental dividend of 6 cents per share based on Q1 adjusted net investment income to shareholders of record as of May 28th, payable on June 30th. pro forma for the impact of the Q1 supplemental dividend. Our quarter and net asset value per share was 1641. If we were to take a step back and think about how our business has performed through the pandemic, one way to do this is to look at the total economic returns, which measures the change in net asset value per share plus cumulative dividends per share. Since January and since the year in 2019, which is just prior to the onset of the pandemic, we've generated a total economic return of 21.8%. Another lens is to look at total net asset value per share growth, which in our case should incorporate our special and supplemental dividends per share. Since year end 2019, we grew our net asset value per share, adjusted for the impact of the special and supplemental dividends by 9.5%. We're pleased that our ongoing focus in building a business model for not only performance, but thrives in periods of market uncertainty, delivered such strong results for our stakeholders. As important, over the past year, our business model allowed us to provide capital to our portfolio companies, their management teams, and sponsors, when many of our competitors weren't able to do so, in order for them to create value for their own respective stakeholders. Having an enduring business model, in spite of the regulatory and other constraints for BDCs, not only provides value for stakeholders, but also allows us to be a stable and certain provider of capital to our portfolio companies. With that, I'll now pass it over to Bo to discuss our portfolio activity and metrics.
spk12: Thanks, Josh. Let me start with some observations on the competitive environment in Q1. With continued accommodative fiscal and monetary policies from the Fed and the U.S. government, investor appetite for risk assets remained elevated, bolstered by the search for yield and prospects for strong near-term growth. This sentiment was evident in the leveraged loan market, where strong demand pushed pricing in terms in favor of borrowers. During Q1, LCD spreads tightened across the securities and rating spectrum. with all-in yields for new issuers reaching post-financial crisis lows. Illiquidity premiums, as measured by the spread differential between large corporate and syndicated middle market loans, fell to seven-year lows, and covenant light as a percentage of new loans issued reached a record high of 89%. In the direct lending market, elevated competition from BDC peers and private funds with record levels of dry powder meant that we continued to skew our originations activities towards opportunities where we had clear competitive advantages as a capital provider. Despite the competitive backdrop, we continued to see borrower demand for financing partners with deep sector expertise and a broad range of underwriting capabilities. For this quarter, we had $145 million of commitments and $130 million of fundings. These fundings were across two new and six upsizes to existing portfolio companies. Our new investments this quarter were both first lien loans for mission-critical software providers with attractive revenue characteristics. We were also active during the quarter by supporting our existing portfolio companies on their strategic growth and capital needs, with nearly 45% of this quarter's fundings serving our existing borrowers. Our repayments in Q1 slowed after a busy 2020, totaling $85 million across four full and three partial investment realizations and sell-downs. This resulted in net funding activity in Q1 of $45 million. The larger repayments this quarter were predominantly M&A driven, with the exception of our $17 million par value Neiman exit term loan. With a strong market backdrop in late March, Neiman issued notes in the high yield market to refinance its exit term loan, which had call protection of 110 at the time of repayment. This call protection, in addition to the acceleration of unamortized OID on our loan, contributed meaningfully to our fees this quarter. Recall on our Q3 2020 earnings call, we disclosed that approximately $4 million of backstop fees related to our exit term loan commitment were booked as OID and that these fees were payable in common stock of the reorg company. Post-quarter end, we sold our entire Neiman equity position at a price above our 331 mark, thereby fully exiting all of our Neiman investment. Looking back, we've been a provider of liquidity and transitional capital for the retailer as its management team navigated through a pandemic and a Chapter 11 process. We believe this has been a fruitful partnership that has allowed both parties to create value for our respective stakeholders. Based on our total capital invested in Neiman's since 2019, we've generated a gross unlevered IRR of approximately 25% on our fully exited investments, which includes the post-quarter end sale of TSLX equity position. Turning now to a quick update on JCPenney. Recall that in December, upon the company's emergence from Chapter 11, our pre-petition debt and dip loan positions were converted to non-interest-paying instruments, but with rights to immediate and future distributions in cash and other securities. During the quarter, our $13.3 million fair value dip loan position was extinguished in connection with the closing of the PropCo, and we received a small cash distribution along with equity interest in the PropCo. At quarter end, our PropCo equity interest had a level two fair value mark of $18.1 million. Across Q1, our JCPenney investments drove $5.4 million of net realized and unrealized gains, or a positive eight cents per share impact to our NAV this quarter. At quarter end, our portfolio's retail and consumer exposure was 11.4% at fair value, and nearly 80% of this consisted of asset-based loans. Cyclical names, which exclude our asset-based retail loans and energy investments, continued to be limited at 4% of the portfolio, and our energy exposure at quarter end was 1.7%. During Q1, our portfolio's first lien composition decreased slightly from 96% to 95% on a fair value basis, and our equity investments increased slightly on a fair value basis, through the combination of our JCPenney PropCo equity interest as well as valuation tailwinds from a robust equity market and M&A environment. At quarter end, our equity investments represented 4.3% of the portfolio at fair value compared to 3.7% in the prior quarter. In Q1, our portfolio's weighted average yield on debt and income-producing securities at amortized cost was 10.1% compared to 10.2% in the prior quarter. This slight decrease was primarily driven by the impact of new versus exited investments. The weighted average yield at amortized costs on new investments were 10.6% this quarter compared to a yield of 12.8% on exited investments. Shifting now to the portfolio and underwriting in credit quality. We continue to be thoughtful about our loan structuring process with utmost focus on protecting our principal against losses from credit risk and other market factors. At quarter end, We averaged approximately two financial covenants per loan and had effective voting control on 87% of our debt investments. In addition, we continue to have meaningful call protection and LIBOR floors across our debt portfolio. We believe our financial results over the past 12 months underscore our disciplined underwriting and its importance in driving differentiated outcomes. From a credit quality standpoint, we continue to see stable to positive performance trends across the significant majority of our portfolio. Quarter over quarter, non-accruals decreased from 0.9% to 0.02% of the portfolio at fair value, following the completion of American's achievements out of court restructuring. As previewed on our last earnings call, our first lien loan for American achievement remained outstanding post-reorg, and the interest that we received while the loan was on non-accrual status was applied to our loan principal. As part of the restructuring, the lender group received a majority stake of the common equity and subordinated notes in the restructured business. At quarter end, these subordinated notes accounted for all of our outstanding investments on non-accrual status at fair value. This quarter, our portfolio's weighted average performance rating on a scale of 1 to 5, with 1 being the strongest, was 1.14, improving from 1.18 in the prior quarter. And credit metrics across our core borrowers remained relatively stable quarter over quarter, with weighted average attached and detached points of 0.4 times and 4.3 times, respectively. The weighted average interest coverage on our core borrowers was stable at 3.2 times at quarter end. With that, I'd like to turn it over to Ian.
spk07: Thanks, Mo. In Q1, we reported adjusted net investment income per share of 53 cents and adjusted net income per share of 88 cents. As Josh mentioned, we have approximately $0.07 per share of accrued capital gains incentive fee expenses this quarter. Inclusive of this non-cash expense, our net investment income and net income per share were $0.46 and $0.81, respectively. At March 31, we had total investments at fair value of $2.4 billion, up from $2.3 billion in the prior quarter as a result of net portfolio fundings as well as the positive impact of valuations on the fair value of our investments. Total principal debt outstanding was $1.1 billion, and net assets were $1.2 billion, or $16.47 per share, which is prior to the impact of the supplemental dividend that was declared yesterday. Average debt to equity during the quarter was 0.93 times, up from 0.87 times in the prior quarter, and the quarter end debt to equity ratio was 0.92 times. Note that shortly after quarter end, we drew on our revolving credit facility to facilitate the payment of our $1.25 per share special dividend, which had a record date of March 25. Pro forma for this revolver draw, our quarter-end debt to equity ratio would have been approximately one times, and our quarter-end liquidity would have been $1.2 billion against $93 million of unfunded portfolio company commitments eligible to be drawn. As you may know, we did a small equity raise in February, almost immediately on the heels of declaring a special dividend. The leveraging impact of a dividend payment, in combination with our healthy investment pipeline and visibility on limited near-term repayments, implied that our pro forma leverage would be on the higher end of our target leverage range of 0.9 to 1.25 times. In order to preserve our reinvestment option amid a building pipeline of opportunities, We did a small equity issuance sized at less than 6% of our pro forma market cap with net proceeds approximating the size of our special dividend payment. What we did essentially was swap out capital that had excise tax associated with it and replaced it with new capital without the burden of excise tax. This allowed us to create NAV and ROE accretion for our shareholders while remaining leverage neutrals. Turning now to our presentation materials, slide eight is the NAV bridge for the quarter. Walking through the notable drivers of this quarter's NAV growth, we added 46 cents per share from net investment income against our base dividend of 41 cents per share. The equity raised provided 23 cents per share of standalone accretion to NAV, which when we take into account the impact of dividends on the newly issued shares, netted an actual NAV accretion of approximately 13 cents per share. There was a 21 cents per share reduction to NAV as we reversed net unrealized gains on the balance sheet related to investment realizations and recognized these gains into this quarter's income. The impact of tightening credit spreads on the valuation of our portfolio had a positive 15 cents per share impact. And there was a positive 42 cents per share impact from other changes, primarily driven by net realized gains on investments of 21 cents per share and other net unrealized gains from portfolio company specific events. The realization of our small equity investment in capsule technologies upon its sale to Phillips drove the bulk of our realized gains this quarter. Moving on to our operating results detail on slide nine, total investment income for the quarter was 66.2 million compared to 62.2 million in the prior quarter. Breaking down the components of income, Interest and dividend income was $55.9 million, up $3.2 million from the prior quarter, primarily due to the increase in the average size of our portfolio. Other fees, the majority of which consisted of prepayment fees and accelerated amortization of upfront fees from the Neiman exit term loan prepayment, were $8 million compared to $4.3 million in the prior quarter. Other income was lower at $2.3 million compared to $5.2 million in the prior quarter. Net expenses, excluding the impact of non-cash accrual related to capital gains incentives fees, were 29 million, up 2.7 million from the prior quarter. This was primarily led by higher other operating expenses compared to the lower seasonally adjusted other operating expenses that we had in Q4. Note that our annualized Q1 operating expenses as a percentage of total investments at fair value was 58 basis points. in line with our trailing four-quarter average of 60 basis points. The weighted average interest rate on our average debt outstanding decreased slightly this quarter by three basis points, primarily due to the shift in funding mix as a result of an increase in the average size of our portfolio. Shifting to yesterday's PENQ filing, you may have noticed that we reported for the first time the calculation of diluted EPS on our income statement and in the notes on our financial statements. This accounting disclosure was triggered by the fact that the average share price of our stock exceeded the adjusted conversion price on our 2022 convertible notes during the Q1 reporting period. To satisfy this disclosure requirement, we've chosen to early adopt ASU 2020-06, which requires, among other things, the calculation of diluted earnings per share using the if converted method. This method assumes conversion of our convertible securities at the beginning of the reporting period and is intended to show the maximum dilution effect to common stockholders regardless of how the conversion can actually occur. As mentioned on our last earnings call, we have the flexibility under our 22 convertible notes indenture to settle in cash or stock or a combination thereof. These notes are not eligible for conversion today, But when it comes time to make a determination on settlement method, our decision will be one that, among other considerations, optimizes the impact on our NAV per share, ROEs, financial leverage, and liquidity position. At quarter end, our balance sheet and funding profile were in excellent shape following several liability management actions taken during the quarter. As mentioned on our prior earnings call, this January we capitalized on the attractive issuance environment in the investment-grade capital markets and issued $300 million of 2.5%, 5.5-year unsecured notes. And in February, with the ongoing support of our lending partners, we increased the commitments under our revolving credit facility from $1.335 billion to $1.485 billion and extended the final maturity on $1.39 billion of these commitments to February 2026. Subsequent to quarter end, the maturity on an additional $70 million of existing revolver commitments was also extended to February 2026. Performer for the impact of the special dividend payment post-quarter end, our total liquidity at quarter end represented 51% of our total assets, and unsecured debt represented 79% of our quarter end funding mix. Further, the weighted average remaining life of our debt funding was 4.3 years, compared to a weighted average remaining life of investments funded by debt at quarter end of only 2.4 years. As we look ahead to the year, we continue to target a return on equity of 11.5 percent to 12 percent, corresponding to a range of $1.82 to $1.90 for full year 2021 adjusted net investment income per share. Note that this target range excludes the impact of any accrued capital gains incentive fee expenses. With that, I'd like to turn it back to Josh for concluding remarks.
spk02: Thank you, Ian. I'd like to close our prepared remarks here by encouraging our shareholders of record for our upcoming annual meeting and special meetings on May 26th to participate and vote. Consistent with the past four years, we're 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 stockholder authorization granted to us for each of the past four years, and we have no current plans to do so. We merely view the authorization as an important tool for value creation and financial stability in periods of market volatility. The earlier days of the pandemic were a case study on how periods of volatility often provide highly attractive return on equity opportunities. when it's more likely that our stock would trade below net asset value. As you know, as we were well positioned heading into the pandemic with ample liquidity and capital cushion, and therefore we were able to opportunistically deploy capital, create shareholder value without needing to access this tool for financial flexibility. Looking ahead, those who know us know that our bar for raising equity is high. We only raise equity when trading above net asset value on a very disciplined basis, so we would only exercise the authorization to issue shares below net asset value if there was a sufficiently high risk-adjusted return opportunity that would ultimately be accretive to our shareholders through overrunning our cost of capital and the associated dilution. If anyone has questions on this topic, please don't hesitate to reach out to us. We've also provided a presentation which walks through this analysis. and investor resources section of our website. Turning out to our sector in the broader private credit markets, it's hard not to take the opportunity to be a little reflective post the shock to the global economy, which the pandemic provided, coupled with the fact that the private credit asset class has grown at a meaningful pace. In our humble opinion, much of the sector has failed to earn its cost of capital and provide value to shareholders. With a return on equity on net income over the last year of approximately 2.1% and 5.5% on average since our March 2014 IPO. We think this reflects a failure to understand one's cost of capital, price credit spreads, which includes one's fees and expenses, and to incorporate credit losses into one's economic model. This clearly shows in our sector's net asset value for shared degradation of the LTN period of approximately 6.5%. and a cumulative net asset value per share, a degradation of approximately 15.5% since our March 2014 IPO. We spent a lot of time thinking about the keys to a successful business model. Ultimately, we believe, is what allows you to provide value across market environments to your investors, as well as portfolio companies, management teams, and sponsors, even though these two goals may seem at times at odds with each other. By adding resiliency to the left and right-hand sides of our balance sheet through, among other things, focusing on sector selection, proactive liability management, and maintaining appropriate liquidity and capital cushions, we'd be able to be a source of stability and capital for our clients, including portfolio companies, management teams, and sponsors during periods of uncertainty, while providing adequate returns to our shareholders. Critical to this has been our focus on finding a balance of scale. That is to ensure that we bring deep sector expertise and capital to help an issuer to achieve its goals, but also create sustainable value for stakeholders in an environment where there's finite alpha direct lending assets. To date, we've achieved this by sizing our BDC strategically based on our view of the market opportunity set and being part of the $50 billion Sixth Street platform. which has significant resources to benefit portfolio companies, management teams, and sponsors. Finally, one more topic related to voting. Our broader Sixth Street business over the past year has joined other organizations in pursuing efforts to strengthen access to voting in the United States. These include the Civic Alliance, which is a coalition of businesses supporting safe and accessible elections. And last month, we joined a group a growing list of corporate general counsels and law firm managing partners in a statement denouncing efforts to restrict the constitutional right for eligible Americans to vote. The statement signed by 6th Street General Counsel calls for leadership from our elected officials to take a stand against election laws that disenfranchise underrepresented groups across our country. We are proud to stand by our core democratic values and join our peers in the business community on these initiatives. With that, thank you for your time today. Operator, please open the line for questions.
spk09: Thank you. As a reminder, ladies and gentlemen, to ask the question, you will need to press star then 1 on your telephone. To withdraw your question, press the pound key. Again, that's star 1 to ask the question. Please stand by while we compile the Q&A roster. Our first question comes from the line of Melissa Weddell with JP Morgan. Your line is open.
spk01: Thanks, everyone. Appreciate you taking my questions today. You provided a lot of information this quarter, and it's much appreciated. The transparency is quite helpful. I guess just to start off, given the elevated prepayment income that you saw in the first quarter. Certainly over time, you talked about how that can be pretty lumpy. We know that that's going to ebb and flow based on individual developments with portfolio companies. But I'm wondering what your line of sight is into any other developments within the portfolio that we should be thinking about that could drive any volatility on that line item. to the extent that you have any line of sight on it.
spk02: Hey, good morning, Melissa. Thank you. So I think actually this quarter was actually relatively muted as relates to payoffs. So I think payoffs this quarter were 85 million and the correlation between payoffs and accelerated OID and other investment income is relatively high. compared to the average quarter, which is probably two times greater, so around $200 million. And so I think when you look at the attribution in our income statement, I think it was also relatively low. So typically, when you look at it on a per share basis, interest from investments and interest income have been $0.81. It was $0.83 this quarter. interest from investments on the fees have been 13 cents. So that's prepayment fees in this quarter was about 12 cents. So I would say it was probably slightly on the lower side. I think when you look at other income, it was about 3 cents per share compared to historically about 6 cents per share. So all said, I think Relatively low, those other activity-based feeds were relatively low this quarter. And, you know, I think there was a, it was because it was kind of, quite frankly, a little bit of a quiet quarter, both on the origination side and on the payoff side. Anything to add there? I think The other thing is from a, there was obviously Q4 tends to be a large quarter, and there's, you know, pull forward of Q4 from activity Q1. And so you saw, you know, payoffs elevated in Q4. You saw fundings elevated in Q4. So Q1 was kind of, you know, a little bit of a quiet quarter on both the origination and payoff side and a little bit of a quiet quarter quiet quarter on the activity-based, therefore on the activity-based income side. Anything to add there?
spk07: Yeah, I would just add, Melissa, that we look at the amortization of upfront fees from unscheduled payments in tandem with the prepayment fees, if there are any, on a particular payout. So when Josh was quoting the $0.12 per share from that category, that's because we combine those two particular line items. But as he says, that's actually relatively in line with what we've experienced in over the last 10 or so quarters.
spk02: And just a little more detail, that was specifically driven through Neiman. I think Ian, right, which was the unamortized portion was related to when we did the Neiman's exit term loan, we got a backstop fee in Neiman's equity. The fair value of that equity went on the balance sheet of our costs as a cost basis. Therefore, it was the OID against the term loan, and when the term loan paid off, both the prepayment and the accelerated OID, which was the value of the equity, rolled through the income statement.
spk01: All right. I appreciate that. One quick follow-up then. Given sort of the outperformance in 1Q on adjusted NII versus the ROE targets that you established, at the beginning of the year, wondering, you know, you didn't take up the target, and just wondering how you're looking at that for the rest of the year. Thank you.
spk02: Yeah, so, thanks. I mean, look, we try to create a, you know, and hopefully we can keep this up, a history of, you know, beating our guidance, and, you know, which is, you know, kind of looking at the base earnings and core earnings where we have a highly confident, you know, a highly confident number on return on equity and NI per share. And, you know, when you set a very high confidence of, you know, 95%, you oftentimes exceed it. So, you know, if you set a confidence level of 50%, you know, half the time you'll exceed it and half the time you won't exceed it. So when we give our guidance per share, we're really trying to set a confidence level of, you know, 95%. Thanks, guys.
spk09: Thank you. Our next question comes from the line of Devin Ryan with JMP Securities. Your line is open.
spk05: Great. Good morning, everyone, and thanks for the overview. First question just on kind of the investing landscape. So the spread on new investments has come down clearly relative to kind of the peak levels. It's kind of the peak of the pandemic, but you're still meaningfully above pre-pandemic levels. So just a little maybe more color on whether that's the types of deals you guys are putting in the portfolio or are you still seeing deals broadly pricing at a premium today?
spk02: Yeah, I mean, I'll turn it over to Beau. I mean, look, the challenge with looking at any one quarter is it kind of moves around because the sample size is pretty low. I would say this quarter was broadly kind of reflective of the things we're trying to focus on and do. We'll do things tighter. We'll do some things wider. But I think it's broadly reflective of I think generally on the investing environment, the big theme, and you see this across risk premiums, across asset classes, or most asset classes, and there are some industries that this doesn't exist for, for example, real estate. But the cycle is kind of skipped. And so when you look at, and people are pricing and underwriting standards are kind of assuming that, which I think is broadly right. And so things are competitive, pricing is getting tighter, and again, the cycle has skipped. Consumers have excess savings, are in the greatest health they've ever been in, Now, there's obviously distribution across those consumers, but broadly speaking, that's the case. Corporates are in relatively good shape, especially given low interest rates, and financials are in great shape. Most of the pandemic pain was felt on the government's balance sheet. And so... I think broadly speaking, we're kind of back into the first or second inning. I do not think we're in the 10th or 11th inning overtime of a cycle. We're kind of back at the beginning. The cycle has skipped, and I think people are pricing risk premiums that way, which is expected low defaults and defaults given recoveries given defaults will probably be pretty high for the next couple of years.
spk05: Okay. Appreciate it. That's a great color. Maybe a bigger picture one, Josh, if you can. Just always appreciate your view on the industry more broadly. You know, clearly, you know, here we sit today, you know, roughly a year past, you know, more than a year past the start of the pandemic. And you're looking at your portfolio. It's in terrific shape. Non-accruals are down to, you know, 0.1% of the portfolio cost. You know, the overall portfolio has performed, you know, incredibly well and obviously a very strong quarter, you know, so good. As we think about just kind of the business models, we've just kind of gone through a real-life stress test. You know, how do you think about kind of the case for maybe a further re-rating in the stock or maybe in the space more broadly and kind of distinguish between, you know, the leading firms that really kind of showcase how well they can perform in an environment like last year versus, you know, maybe firms that didn't fare as well. You know, now that we can kind of look back a little bit in retrospect, a little color from you.
spk02: Yeah, I'll give you a couple of swing thoughts. First of all, I think we didn't really experience the cycle. Now, there was mostly dispersion. There was very significant dispersion around managers, but quite frankly, you know, you didn't really feel the full weight of a cycle given the fiscal monetary stimulus. And so, you know, I don't know if people can should or think about expecting that every, you know, going forward. Given that return on equity in the space was, you know, on average, I think was 2%. Now, that will come up a little bit because NAVs have increased this quarter. But, you know, it was quite frankly relatively, you know, not great, although there were people who had great performance. I think our return on equity, you know, for the year last year was 15.8%. And, you know, some of our peers, you know, Aries had a great year. Some of, you know, people had, you know, there were most definitely people outperformed. I think generally what you're seeing in valuations, I think the space has re-rated. I think you're seeing the space trade at or closer to net asset value, which I don't think since we've been public has been really the case. And I think you're seeing greater dispersion on both the left tail and the right tail based on performance. And so I think it's most definitely – I think it's kind of getting to a healthy spot where – You know, where the asset class or where the sector was when we first did this post-global financial crisis was, you know, looked at pretty negatively by a lot of institutional investors. And now I think, you know, people can see the dispersion, and that dispersion is based on skill sets and talents of management teams and business models and how they approach the market. I think I like it and I think you know you know I think hopefully sponsors and issuers and users of capital you know put that in their own model which is in their head which is they hopefully they value a stable source of capital for as in their partnerships and for their portfolio companies and and people who understand the sector and that they, you know, and that value, that stable source of capital will be valued to their own, you know, their own endeavors. And so I think for production, I don't know about anything to add or Fishman. Fishman's always a guest speaker on this because, He has the most wisdom out of everybody. Don't laugh when I say Fishman has wisdom. He actually does.
spk12: Anything to add, Bo? No, I think that was well said, Josh. I think the dispersion of managers wasn't fully tested, given the unprecedented fiscal and monetary stimulus. But we'll have regular cycles again at some point. That will be reflected in the results, but I agree largely with your thoughts.
spk05: Okay, terrific. Well, I'll leave it there. Thank you, guys.
spk02: Great, Devin. Thank you so much.
spk09: Thank you. Our next question comes from the line of Ryan Lynch with KBW. Your line is open.
spk10: Hey, good morning. Thanks for taking my questions. First one is you guys are clearly a very big lender into the software space. And as the market continues to evolve and as software becomes a more desirable sector to lend to, it seems like annual recurring revenue lending is becoming more and more prevalent. From your standpoint, since you guys track in the software space a lot, how do you think about lending on ARR versus cash flow to these software companies? And then just a high-level ballpark, what percentage of your portfolio and your software names were those initial loans done on an ARR versus a cash flow lending basis? Yeah, thanks for that.
spk02: We'll come back to you on the latter part of the question. I don't know if we have it off the top of our head, but we'll come back to you. On the first part of your question, look, I would say we're investors. And not every dollar of cash flow is created equal and not every dollar of subscription revenue AR is created equal. And so I think, you know, unfortunately, given the buoyancy of the software space, which has kind of risen all boats, that those business models haven't been tested. And so we're extremely focused on quality business models and business models that are robust. And so it really is, you know, there are some businesses that we think that have good return on capital or are investing a ton, best-in-class unit economics and we want them to grow and switching costs are high and we want to support those those companies and their growth endeavors and so ARR structure works and you know there are some cash flow companies that we think in the software space cash flow deals in the software space that you know for example that EBITDA is not burdened by R&D capitalized R&D that churn is high, that there's a whole bunch of technical debt and margins are not sustainable given the technical debt, and that we won't lend to on a cash flow basis. And so we're investors. And so what I would say is not every dollar of AR is created equal, not every dollar of EBITDA is created equal. and you really got to look at business models and how robust those business models are. Bo or Fish, do you have anything to add?
spk12: Yeah, the only thing I would add is we've been lending broadly to the technology sector, which includes software, for over 20 years and have developed a lot of pattern recognition along the way on how various end markets within technology you know, perform through cycles. You know, we're very nuanced in our approach. We're focused thematically in subsectors. We don't think of software as a sector. It's omnipresent. It's, you know, obviously the digitization of the economy is happening before us and it's probably accelerated through COVID. So you're feeling a lot of tailwinds from that. But we get very nuanced within, you know, within the subsectors and figure out areas that we feel like there's going to be ongoing strong unit economics and a return on invested capital in this space. But to Josh's point, we don't look at investments as investors. We don't look at an ARR loan or a cash flow loan differently. We're pressure testing how we think those revenue streams are going to perform and what our margin of safety is. if things don't go to plan.
spk04: I would just add we also look through to the end markets. Lending to a software business going through the pandemic in the restaurant industry or the cruise industry is a lot different than if we were lending to the grocery or retail or different parts of the retail industry. So we pay attention. There's no shortcut. You have to pay attention to a lot of factors. and markets being one of them because, as Bo said, technology is ubiquitous, and you've got to dig deeper in your analysis.
spk02: As always, Fishy comes in with the wisdom, rounding out not every dollar of EBITDA or recurring revenue is created equal, and markets matter. Fishy, thank you for your dead-on.
spk10: Thanks, I appreciate it.
spk02: Is that helpful, Ryan?
spk10: Yeah, yeah, that's helpful. I got a response from the full team. The other question I did have, and you mentioned it, you guys brought it up on the call, you know, the convertible bonds. You guys are now, you know, doing different, you know, showing some different reporting methods on that. And so, you know, I know that's still, you know, a little bit over a year away of when, you know, that will actually become due, and you guys have to make a decision on how to repay that. But as we sit here today, I guess, preliminarily, you know, if you guys had to convert that today, you know, what would you guys look to do? Because it looks like if you guys, you know, paid that off with issuing shares, it looks like that could be a creative denab, would be a deleveraging event. paid it off in cash, it looks like, you know, it'd probably be diluted to NAV, but it wouldn't be a deleveraging event, you know, based on, you know, my math.
spk02: Right. You're dead on. So the good news is we get the, it's not binary. We have flex on how we settle, how much cash in stock. And, you know, you hit the bookends exactly right. And so it's going to be a function of the framework is... you know, where we are at the equity, you know, how dilutive is it on ROEs and NAV or how creative it is on ROEs and NAV, and we have the flexibility of settling, you know, the flexibility of settling on how we settle that. And so I think the bookends in are we settle all, and again, it's not binary, so we're in between these bookends. but if we settle all in cash, it's dilutive, and it doesn't go through the P&L, it goes through APEC, but it is dilutive per share of what, Ian? 36 cents. And if we settle all in stock, it's... It's accreted by 16 cents. So that will be a function of where we're sitting, how much capital we have, and where obviously the good news is We have time, and we can manage it, and we have the ability to fuck settle it, but you hit it.
spk10: Okay. Gotcha. I appreciate the time today and really nice work, guys.
spk02: Thanks. We appreciate it. By the way, that was the hardest financing we've ever done, and it had the most value in it, you know. But that was literally the hardest financing, you know, we ever, you know, had to round up. Obviously, when in hindsight, I think in what we bought back about 27 Yeah, $27 million of those notes at a cost to us of about 90 cents. You know, which was a helpful investment in our own capital structure doing COVID. And so, you know, in hindsight, we wish we could have done more. But, you know, we were not only making in COVID, not only making investments to support portfolio companies, but making investments in our own capital structure that, you know, those two in combination create a lot of value for our shareholders.
spk10: Mm-hmm. Gotcha. Thanks, guys.
spk09: Thank you. Our next question comes from the line of Sonia and O'Shea with Wells Fargo. The line is open.
spk06: Hi, guys. Good morning. Most questions have been asked and answered. Just one here on the dial transaction that looks to be moving along. Does that lead you to pursue any potential ownership change, or have your concerns been subdued by this time?
spk02: Yes. Look, I would say our concerns haven't been subdued. You know, we're obviously very disappointed in the Vice Chancellor's initial decision. We think she got the facts wrong and the law wrong. That's why we appealed. You know, as we said, we honor our deals and we expect our partners to honor their deals, too. You know, we have, again, we have no, you know, we've known the principals at Alrock for many years and a great deal of respect for them as a competitor to our firm. the Delaware Supreme Court yesterday has decided to hear or appeal on an expedited basis. So that is being heard on May 12th. And so they granted, and they're doing it on a on-bank basis. So all five of the justices versus the panel three will hear the appeal on May 12th. Obviously ongoing litigation, and so
spk09: um that's that's all i can say okay the helpful that's all for me thank you thank you as a reminder ladies and gentlemen that's star one to ask the question our next question comes from the lad of robert dodd with raymond james your line is open uh hi guys and congratulations on uh the the the quarter a question on on kind of
spk03: repayment expectations kind of maybe more long term. I mean, I realize Ian's comment, limited near term repayments expected. But if I look at your book, you've got a little over 50% of the debt book marked above 102. Of course, now my presumption is that factoring in corporate, which you structure very well. So the question is, are your concerns elevated about maybe not in the near term but as we go through this this the the rest of this year given how competitive the market is is there elevated risk of of risk is an issue right because you get paid if you get if you get repaid early but elevated risk of maybe portfolio um contraction with repayments or do you think the pipeline is going to be sufficient even in a very competitive market where you're very picky on the credit side, to grow the book this year? Or is the elevated level, what appears to be an elevated level of repayment expectations, a headwind?
spk02: Yeah, actually, look, our expectation is that, you know, in the near term we're going to grow the book. And so, you know, we look at what's out there. There's a couple, but, you know, the pipeline more than offsets it. And so, you know, given, as you know, the interaction between repayments, which typically create, you know, some income, but also deleverage the business, and given the breadth and depth of our sourcing and how we go to market, I feel pretty confident that we're actually, on a net basis, are going to, you know, in the near term. That's the nice thing about being part of a very large platform is we're involved in a whole bunch of sectors and look, I think, again, M&A drives repayments but also drives new deal flow. I actually feel more bullish in our ability to grow the book today than I have historically. Ibo or Fishy, anything to add there?
spk12: No, I think you're spot on. I think historically, when you look at our repayment activity, it's largely been driven, not all the time, but largely been driven by M&A activity, which also, when there's elevated M&A activity, there's also elevated opportunities. I would expect 2021 to have elevated M&A activity. We're seeing that in the formation of the pipeline currently. But with a backdrop of strong asset valuations and expected tax changes, I think you're going to see elevated M&A activity, which will drive both new opportunities and repayments. But I'm with Josh. I'm more bullish on growing the book than there being shrinkage.
spk03: Got it. Got it. Appreciate that. I mean, the question that follows on is it obviously interacts with kind of Ryan's question on the convert. How high, I mean, obviously we know the target range. Would you be willing to operate essentially at the high end of that target range for a I want to say a prolonged period, but obviously one of the options with the convert, it would deleverage you. That's not until August next in 22, right? It's a long time out, but what's the balance there on how high you'd be willing to go? Cause you can always just not do new deals if you get too high, but what's the balance versus the potential of something that's accretive to NAV. If you're, if it's not too deleveraging and, It's a really good outcome on multiple fronts. So what's the view there?
spk02: Yeah, look, as you know, it's summer of next year. And so it's hard to make a call about your capital 18 months from now. And again, you have the ability to flex settle, which I think is helpful. So it's not binary. And so I just, you know, it's hard to make a call 18 months. We obviously understand those levers very well, which is all things being equal, you'd rather, you know, do something with the converse that's accreted of the net asset value than dilute of. And so, yeah, you know, if you had perfect visibility, would you like to run a little bit hot knowing that you can settle and, you know, and stock? And, you know, the answer would be yes. But, again, I think that's some time off. We're going to have a lot of more visibility. The good news with time, the nature of time, as time passes, you get more clarity. But we most definitely understand those levers, and as we do with everything, we'll be thoughtful to our shareholders.
spk03: Got it. Thank you.
spk09: Thank you. Our next question comes from the line of Derek Hewitt with Bank of America. Your line is open.
spk11: Good morning everyone and congrats on another strong quarter. So maybe Josh or Bo or even Michael, Sixth Street has been one of the top performing BDCs since inception. back in 2013. So how should we think about the size of the portfolio, kind of given your investment strategy, plus just the overall growth in private credit? Or kind of in other words, are there enough opportunities to potentially double or even triple the size of the portfolio in either the intermediate or longer term?
spk02: Yeah. Hey, Derek, it's good to hear from you. Look, I don't think we're actually, like, you know, the hallmark of how we've always run the BDC is we're focused on shareholder returns and not growing assets. And so if we can find assets that provide, that earn or exceed our cost of capital and provide shareholder returns, you know, we'll grow. If we can't, we will not. And, you know, we've sized the book to be, you know, fully invested in in the trough opportunity set. So we have a growth, and I think we try to hit this a little bit, which is growth is not a, let me put it this way. One of the reasons why we think we've had the performance we have for shareholders is the way we think about how we don't grow the book just to grow the book, we think of shareholders first. And we will continue to think about the world that way. And we work for shareholders. The funny thing is that I know the space kind of thinks about the asset management space thinks about themselves as having permanent capital. And the way we think about the world is a little bit differently, which is we don't have permanent capital. Our shareholders have permanent capital. We just happen to manage it on a year-to-year basis, and we'll continue to work hard for shareholders. And so that our board and our shareholders keep inviting us back to manage those assets.
spk11: Okay, great. Thank you.
spk09: Thank you. I'm sure no further questions in the queue. I would now like to turn the call back over to Joshua for closing remarks.
spk02: Great. Thank you so much for everybody's participation. You know, we'll speak to you at the end of the summer, if not sooner. And then obviously Mother's Day is coming up. So obviously, you know, to all the mothers out there, thank you for supporting us. your families during a very difficult time, and obviously the pandemic has most definitely been hard. And my guess is some of that, you know, a lot or some of that burden has fallen on your shoulders. So thank you, and we'll talk soon. Bye.
spk09: Ladies and gentlemen, this concludes today's conference call. Thank you for your participation. You may now disconnect.
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