Sixth Street Specialty Lending, Inc.

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. Cammie 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 6th Street Specialty Lending Inc.' 's filings with the Securities and Exchange Commission. The company assumes no obligation to update any such forward-looking statements. Yesterday, after the market closed, we issued our earnings press release for the second quarter ended June 30, 2024, and posted a presentation to the Investor Resources section of our website, www.6thStreetSpecialtyLending.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.

Thank you, Cammie. Good morning, everyone, and thank you for joining us. With us is our president, Bo Stanley, and our CFO, Ian Simmons. For the call today, I will provide highlights of this quarter's results and pass it over to Bo to discuss activity in the portfolio. He 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 58 cents per share for 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 and , were both a penny 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, prior to the impact of special and supplemental dividends redistributed 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 46 cents 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 gap 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 out in Q1 results as net income ROEs for our peer set for 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 Beau, I'd like to take a big step back to emphasize that we're in the business of creating value for our shareholders. At a minimum, that means earning our cost of equity, but our goal has always been to exceed it. Given the rapid change in the spread environment in private credit, there's one key question operators should be asking themselves, which is, was the required spread on investments to earn that cost of equity? This is a framework that guides us to maintain an investment selectivity and discipline in a competitive market environment. We are actively passing on deals getting done at spreads that would generate an estimated return that is below the industry's cost of equity. We acknowledge that pricing floor exists in the BC model, and capital should not be allocated to investments being low-circumstance spread. We'll walk through this in detail now to clearly demonstrate that operating a successful BDC is about disciplining the 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 a 10-year treasury rate. For simplicity, will assume management and incentive fees, leverage, cost of funds, and operating expenses are based on the LPM average for the sector. While management incentive fee structures as well as leverage vary across 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 to 130 basis points on assets according to Cliffwater Drug Lending Index. Including credit losses based on this data, the required spread applying our cost of equity assumptions, 750 to 780 basis points. To explicitly show why we are passing on deals getting done at a spread of 450 basis points and below, the return on equity before credit losses is 6.3% and 3.4 to 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 outlined 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 rate average spread of new investments this quarter was 6.6%. If we apply a spread of 660 basis points to our unit economics model, including activity-based fees on a three-year historical average, leverage of 1.2x, and credit losses between zero and 50 basis points. The output is 11% to 12% return on equity. Again, this math is basically a weighted average of one-quarter of new investments, which compares to a weighted average spread with a portfolio fair value of 8%. This clearly indicates that we are continuing to overrun our costs 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 the base quarterly dividend of 46 cents per shareholder of record as of September 16th, payable on September 30th. Our Board also declared a supplemental dividend of 6 cents 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 performed for the impact of the supplemental dividend that was declared yesterday at $17.13. And we estimate that our spillover income per share is approximately $1.15.