Sixth Street Specialty Lending, Inc. (TSLX) Earnings Call Transcript & Summary

Good morning, and welcome to Sixth Street Specialty Lending, Inc.'s Second Quarter ended June 30, 2024, Earnings Conference Call. [Operator Instructions]. As a reminder, this conference is being recorded on Thursday, August 1, 2024. I'll now turn the call over to Ms. Cami VanHorn, Head of Investor Relations.

Thank you. Before we begin today's call, I would like to remind our listeners that remarks made during the call may contain forward-looking statements. Statements other than statements of historical facts made during this call may constitute forward-looking statements that 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 30, 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 30, 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, Cami. Good morning, everyone, and thank you for joining us. With us as 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 in 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 statement, our Q2 net investment income and net income per share inclusive of the unwind of the noncash accrued capital gains incentive fee expense were both $0.01 per share higher. At June 30, our net asset value per share reached a new all-time high at $17.19, representing an increase of 2.7% year-over-year in an annualized growth of 3.4% since inception, part the impact of special and supplemental dividends were distributed over that time. We don't want to sound like a broken record, but our outlook for this 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 bottomed 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 2 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 potential for credit losses. We started to see this play on Q1 results as net income ROEs for peer set were approximately 140 basis points below operating ROEs. We slightly outperformed these results in Q1. This dispersion highlights the growing sales 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, well, 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 fund environment and private credit is one key question, operator should be asking themselves, which is what is 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 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 in low certain spread. We'll walk through this in detail now to clearly demonstrate that operating a successful BDC is about discipline of capital allocation. We'll start with the assumption of the average cost of equity for a publicly traded BDC of 9.4%. This is based on that data source from Bloomberg across our peer set, which incorporates its continued treasury. For simplicity we will assume management and incentive fees, leverage, cost of funds and operating expenses are based on the LTM average for the sector. While management incentive fee structures as well as leverage vary across the industry, these minor differences do not result in a different conclusion. Using the current 3-year SOFR swap rate of approximately 4%, 1.5% OID over a 3-year average life, the required portfolio spread to earn a 9.4% cost of equity is approximately 620 basis points from 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 before the impact of credit losses. Historically, annual credit losses have averaged approximately 100 to 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 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 at 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 constructive 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 economic model, including activity-based fees on a 3-year historical average, leverage at 1.2x and credit losses between 0 and 50 basis points, the output is 11% to 12% return on equity. Again, this math is basically a weighted average of 1 quarter's new investments, which compares to a weighted average spread in the portfolio at fair value of 8%. This clearly indicates that we are continuing to over earn our cost of equity. Our track record of generating a 13.5% annualized ROE on net income since our IPO in 2014 further demonstrates its consistency. Yesterday, our Board approved a base quarterly dividend of $0.46 per share to shareholders of record as of September 16, payable on September 30. Our Board also declared a supplemental dividend of $0.06 per share related to our Q2 earnings to shareholders of record as of August 30, payable on September 20. Our net asset value per share pro forma for the impact of the supplemental dividend that was declared yesterday to $17.30 and 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.

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 2 years. While not yet back to the pre-rate hike levels, green shoots in the deal environment contributed 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 8 new and 5 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 for 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 on a senior secured credit facility to merit software holdings. This investment is reflected in our core competency in the middle market where our direct relationship position us well to be a solutions provider for companies like Marriott. Through our connectivity across the 6 REIT platform, we have multiple touch points with the company from inception of the business till we executed on the transaction. Additionally, our expertise in niche markets allowed us to move quickly in with certainty to finance this company of best-in-class SMB vertical market software businesses. On the repayment side, tighter spreads triggered a long way to 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, 2 refis in the private credit market and 1 refinancing to a bank loan. We also experienced a payoff in our retail ABL 3, 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 5 of our 6 full payoffs being 2020 and 2021 investments and the other being from 2017. We owned $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 differentiate our portfolio relative to the sector, increase 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 2 largest payoffs during the quarter, ReliaQuest 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 team within our portfolio was our investment at 99 Cents. 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 a 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 nonaccruals 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 of 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 cost. While spreads tighten 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, continue to have conservative weighted average attach and detach points of 0.6x and 5.0x, respectively. 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 borrower EBITDA. As of Q2 2024, the weighted average revenue and EBITDA of our core portfolio companies was $310.4 million and $104.4 million, respectively. There were no new investments added to nonaccrual 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.

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 1.19x as of March 31 to 1.12x as of June 30, and our weighted average debt-to-equity ratio for Q2 was 1.17x. 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 revolver capacity quarter end against $250 million of unfunded portfolio that 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 the 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 revolver 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 revolver capacity to reach the top end of our target leverage range of 1.25x debt to equity and further drawdown 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 '26, '28 and '29 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 of increase 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. Working through the main drivers of NAV growth, the over-allotment shares issued in April related to our equity raise in February resulted in $0.02 per share upward 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 detailed 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 paydowns 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 noncash 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 for 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 $0.01 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 to $2.41, corresponding to a return on equity of 13.4% to 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.

Thank you, Ian. During this time of significant growth in the private credit market, with 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 2 ways. First, we size our capital base as the opportunity set. This means running a constrained balance sheet such that we can operate within a targeted leverage range without broader market participation in deals that we do not think present, appropriate risk-adjusted returns or meets our required return on equity. We accomplished the objective by taking a thoughtful approach to growth regardless of our ongoing ability to raise capital. And second is investing in the platform that has a wide origination funnel. Despite the competitive backdrop like it is today, we remain 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, leading the sector themes and most importantly, pass on investments that do not meet the risk return and absolute return profile 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 the time today. Operator, please open the line for questions.

[Operator Instructions] Our first question comes from the line of Finian O'Shea with WFS.

Taking some of the opening comments on the market, there's, I think, 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 in credit underwriting or are there more firms out there that can do complexity at scale?

Fin, so it's in the straight kind of sponsor stuff, sort of vanilla stuff. I think I would flag 2 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, put some place in the cost curve with 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 sponsored 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 basis -- 20 or 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 nonsponsor stuff. And so for example, in the pipeline is like 860 spread and that's before fees, and that's predominantly known sponsor stuff. So I think it's mostly in the sponsor stuff. And again, I think the relationship of how the size of your origination platform, your capabilities compared to the size of your capital are really, really important and being able to continue to create shareholder value.

That's very helpful. And a follow-up on Europe that seem 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?

Yes. Yes. So look, we're -- I would say when you look at Europe, I think it's -- 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 SLX has the ability to continue to invest in deals. And so it needs to take a position day 1 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.

Yes, for sure.

So -- but again, I think it's by number or by dollars 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 the kind of the eBay auction assets in Europe. And that has a nice spread compared to what you can find in the U.S.

Our next question comes from the line of Brian Mckenna with Citizens JMP.

So you 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 and loans? And then, I guess, what does all that mean for kind of the underlying performance of the portfolio from here?

Yes. Brian, so I would frame it. So just I would -- 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 are slightly below our target leverage going into the rate hiking cycle plus we did -- we were able to raise that. We had to convert -- and I think we did 2 equity raises -- so it's really that it wasn't the portfolio location where the portfolio composition changed not because of turnover. Turnover has been light post-rate hiking cycle. You could see that in -- starting to pick up, but you could see that actually in the activity-based fees. I think going forward, as I said pivots, which feel like they set up to pivot in September, deal activity picks up, spreads coming -- spreads have already started to come in, but the 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, SLX shareholders would benefit from because activity-based fees will pick up. And you saw those activity-based fees pick up -- so this is the first quarter we had a little bit of -- we had a -- we had net repayments and activity-based fees picked up this quarter slightly in line with that.

Okay. Helpful. And then just a bigger question here, Josh. It will be great just 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 '25, capital markets activities 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?

So it's a tricky -- it's a tricky environment. Actually, I'm 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 value writing standards had 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 3 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, you see that a little bit. I think you'll see that continue a little bit. So -- but I'm -- the economy is most separately 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 be cohorts like the consumer especially lower end that are -- that will be pinch points and pain points, and then on the geopolitical, who knows?

Our next question comes from the line of Mark Hughes with Truist Securities.

Your rate on the deal flow, has that changed materially over the last 6 months just that if you're having to be more selective. How is that working out in terms of your success rate with it?

Yes. I would say -- look, I -- when you look at -- I'd say, generally, our head 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. But -- 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 '25 and '26. And even though that we have a back book with a higher yield, we want to be cognizant of making sure we earn our return on equity. So I think our hit rates similar except that there are things that we like the credits, we just don't like the prices.

Yes. 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?

No. I mean, no, that's a reflection of the co-investment strategy where in European deals or large cap deals, SLX for European deals have taken a smaller position. And so there's like a whole bunch of -- on the European deals like $5 million to $6 million dragging it down. But if you look at like the core positions like Marriott, Adevinta, those were kind of $35 million, $40 million commitment. So it's a little bit more of that just participation and how the co-investment -- the new co-investment order REITs.

Yes. I think you mentioned the more toeholds. And then final question, the -- you described how spreads in the pipeline are looking better as you've shifted from the sponsor to nonsponsor. Is that the broader market helping support that? Or is that more intentionality on your part?

I mean the great thing about being part of, as people know, Sixth Street is a $80 billion platform and having this wide aperture that we get the toggle between things. So we did this quarter, nonsponsor, we did Apellis which is a pharma deal. We like that space. We like -- I think there's probably more to come. We did a retail ABL financing, the consumers we can -- that safety is a capital again, and that was done post quarter end, which is a nonsponsored deal. So we're -- we kind of -- the great news is having a big wide top of the funnel, we get to be picky and choosy and making sure we're driving shareholder return.

Our next question comes from the line of Mickey Schleien with Ladenburg.

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 an 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?

I think 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 1 or 2 earnings calls. So it's good to hear your voice. You always have very good questions. My sense is the 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 that M&A environment, there wasn't that natural demand from M&A. And so my sense is that we'll get back in equilibrium here surely with the Fed cutting and more M&A picking up. And so -- but we were kind of in this the supply kind of outpaced demand early on. And we've always wanted to be very disciplined. And the incentives from managers to put that to work and earn fees, et cetera, those are real incentives, and we've always tried to fight those and acknowledge those incentives and be fight those incentives and think about the long-term of shareholder experience. So my hope is that with more demand coming from a loosening environment that will drive M&A and will drive investment in CapEx and growth that the supply and demand kind of will get more imbalanced.

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

Yes. Look, the -- I have a whole thing about this. So the specific 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 specific risk rolling causes comes from a little bit of that -- some of that put obligation for taxpayers, and that is effectively through the FDIC program, backstop asset choices for banks. The second thing is most systemic risk has come from an ALM issue and -- which is that people are long assets and short liabilities and -- that does not exist in private credit. And private credit match funded the ALM. We talked about the soften, but I think the average life of our assets fund with leverage is like 2.5 years versus leverage is like 4 years. And so we actually have small reinvestment risk, let alone liquidity risk. And that is where most kind of systemic or issues that come with financial institutions. The third thing I would say is BDC specifically in private credit as compared to the banks hold somewhere between 4, 3 and 5x amount of capital spent. And so risk-bearing capital on BDCs are about 45% to 50%. If you think about 1x leverage or 1.1x leverage and bank sale about 8% capital. And so the idea that there is real systemic risk overall with the loss of 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 2 business models, for listeners. One business model is that you win long -- you own 8% capital, you win long, you bar short. The other business models you hold 50% capital, you are totally match funded. And I would say, academically, what would be the required return on equity of those 2 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 bank's return on equity requirement in 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 ALM. Is that helpful, Mickey?

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 the 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?

Yes. Lithium is purely idiosyncratic. So it probably -- like the one thing I would be critical on the margin of us in the space, is that when COVID hit everybody thought about negative -- businesses that were negatively impacted by COVID. There were some businesses that were positively impacted by COVID. This was a software business that had levered engagement online and through social media platforms, that was probably a positive tailwind that's unwound. So it's purely idiosyncratic.

Our next question comes from the line of Kenneth Lee with RBC.

Sounds like in terms of the new originations, new investments you're seeing, there might be a little bit of a spread tending 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?

Look, I would say, document that's been pretty stable. So I think underwriting standards remain good in private credit. I mean the question again is like where we sit on the cost curve, what's the required spread to earn your cost of equity. And if that was critical in one place, there would be people not understanding where they spend in the cost curve or where they're leaning too much into their back book. But the things you do today are the ROEs in '25 and '26. But the weighted average financial covenants and all that stuff is basically the same and the docs are in pretty good shape.

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

Yes. Look, I think it's -- again, I think the complexity is -- I think there's 2 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 persecute with less people. And so their eyes will go that way. And so I think you have 2 kind of compounding effect, which is the tails are growing, which will provide opportunity for us in complexity. And as M&A picks up, people's natural kind of glare will be focused on that. And so I think I'm pretty bullish about the next couple of years for our complexity theme.

Our next question comes from the line of Paul Johnson with KBW.

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

Yes. 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 involve, we were involved. So I can't add anything specific. I would say my understanding of that situation is that doc seem like a -- it was a doc that was kind of not -- slightly outside of the range of the existing docs -- service adoption in our portfolio, as I understand it. And the good thing is, is that it wasn't done there was no lender on lender violence that existed, like you've seen the broadly syndicated more loan market, where there's a 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. So -- and then you're also seeing -- so I think that -- I don't see that as a -- 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 a sponsor concentration. Over -- historically, we've done about 55% sponsor stuff, 35% nonsponsor and existing book today. We have no sponsor above 10%. So it's -- and we have like 45 or 50 sponsors in the book. So I don't -- I'm not -- I don't see -- I would see them related, but I think I answered your question, if that's helpful.

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

I would never blame -- I can't really speak to -- I don't want to speak to -- I'm not involved. So I don't have the things that are going to happen in our business, things -- we've been very good on the credit side and stuff pops up so thing is going to happen. Like part of our business is a little bit about a lot of our business. The only thing about the 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 in 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 that wrong. And that -- 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 the Pluralsight specifically.

Got it. Appreciate that. Yes, I was just kind of asking a little bit more broadly on the space, but I appreciate the answers and congrats on the good quarter.

Look, I would never blame something on the service provider. So we're principles. We own our decisions. So like lawyers -- tough to blame on lawyers, their service providers were principles. And so we're -- when there's a mistake, I own it. We own it as a team.

Our next question comes from the line of Melissa Wedel with JPMorgan.

Most of mine have actually been asked already. A quick clarification. When you talked about the pipeline, kind of going forward. Did you -- did I miss it? Or did you size that at all for us?

Yes. So I'll hit it real quick. Like look, the -- you missed it. It's probably like the near-term soft is a couple of hundred million bucks like in the -- that -- in this next kind of quarter, I think, if that's helpful on the growth side before repayments.

Yes. Got it. I appreciate that. And then separately, kind of digging into the nonsponsor side a little bit. When we hear nonsponsor, 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? Or do those investments is the time line, any different for you versus some of the larger, more maybe owned syndicated across a few under type deals -- sponsored deals?

Yes. So I would say the barrier to entry for why I think we see less competition is for the major, it is a much more difficult, less profitable business. It takes longer, it takes more resources. It takes more time, both on the underrated 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 it's -- I think that's why, historically, it's -- 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 knows -- 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 persecute than earning the same fees on something as that average life of 1.5 years, it was a lot harder to persecute. It's not shocking what people do. But actually, sometimes bigger.

Yes. A lot of times bigger. And the only thing we'd add is, is that these are not necessarily small opportunity. These are large businesses generally.

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

No. So the balance sheet restructuring, sometimes it's exiting bankruptcy, sometimes it's entering bankruptcy and a DIP. Sometimes it's a bridge to somewhere, but they don't know exactly where somewhere is because we have an over-levered balance sheet like Ferrellgas. They didn't really know when we do that deal, where that overlevered balance sheet, we were the senior secured. They don't know exactly where it was going. So a whole host of things. In our spec pharma, R&D -- sorry development or spec pharma stuff.

Our next question comes from the line of Bryce Rowe with B. Riley.

Maybe I wanted to offer one follow-up to Melissa's first question there. Helpful to -- for you all to kind of size up the portfolio in terms of the gross potential at least over the near term. And 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 -- that will offset originations or possible to see some net growth?

Yes. I think our base cases were kind of net flat, flattish, Ian. Is that -- so growth originations will pick up as activity levels pick up, repayments will, which will create economics in the books. But I think net flattish, which we think is good. I would like to have being kind of the -- 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 without having without having to...

That's helpful, Josh. I appreciate it. And maybe a question around some -- 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?

Yes. Look, I don't feel real like 2001, 2008 credit cycle. I just don't see that. But I do think you have elevated tails. Businesses has performed relatively well. The portfolio is growing, 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. But I do see that when you take a step back, that capital pre-COVID, post-COVID was misallocated which will -- which has created tails while you had basically 0% to 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 actually found a pretty decent balance. 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.

Our next question, which is our last question comes from the line of Robert Dodd with Raymond James.

Bryce actually just asked the main question. So about growth. So kind of a little add-on to that. We mentioned if you kind of flat this year, should we expect that to be a result of a little bit of rotation. I mean you talked about more nonsponsored in the quarter coming up. Is that going to be a theme this year, more nonsponsored 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 '25, '26 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?

Yes. 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 set up our business where we have created a whole bunch of options for shareholders on different strategies. Non-sponsored, health care, spec pharma, retail, sponsored, energy. And we go to the top of the funnel. And as allocators of capital, we go to say, where does it overlap where the 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 like -- so I -- we really like that model because that model allows us to drive. We've been a public company now for 10-plus 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 that combination of constrained capital, top of the funnel and the options of what we can pick and then the acknowledgment of where we set 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 on the top of the funnel? I don't know.

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

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

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