Sixth Street Specialty Lending Inc
NYSE:TSLX
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Sixth Street Specialty Lending Inc
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Good day and thank you for standing by. Welcome to the Sixth Street Specialty Lending Q2 2022 Earnings Conference Call. (Operator Instructions)
I would now like to hand the conference over to your speaker for today, Cami VanHorn. You may begin.
Thank you. Before we begin today's call, I would like to remind our listeners that remarks made during the call may contain forward-looking statements. Statements other than statements of historical facts made during this call may constitute forward-looking statements and are not guarantees of future performance or results and involve a number of risks and uncertainties. Actual results may differ materially from those in the forward-looking statements as a result of a number of factors, including those described from time to time in Sixth Street Specialty Lending, Inc. 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, 2022, 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, 2022. 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 today is my partner and our President, Bo Stanley; and our CFO, Ian Simmonds.
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. Ian will review our quarterly financial results in more detail. I will conclude with final remarks before opening the call to Q&A.
In addition to today's earnings call, earnings press release, investor presentation and Form 10-Q, we also published a letter outlining a number of perspectives we thought would be valuable to our stakeholders.
Consistent with our approach to provide additional communication during the first few months of the pandemic, we wanted to share our framework to continue the confidence our stakeholders have placed in the stewardship of their capital. Given the outsized impact of the macroeconomic environment on markets and their forward business, we thought it would be helpful to take the same approach with this quarter's earnings release. We encourage and welcome any feedback.
After market closed yesterday, we reported second quarter financial results with adjusted net investment income per share of $0.42, corresponding to an annualized return on equity based on that adjusted net investment income of 9.9%.
Inclusive of marks in the fair value of our investments, we also reported adjusted net loss per share of $0.30. Our adjusted net loss per share this quarter was driven overwhelmingly by unrealized losses as we incorporated the impact of wider market spreads on the valuation of our portfolio. Given this impact on our financial results, I'd like to spend a moment on the importance of our quarterly valuation framework.
As we said before, we believe that an intellectually honest framework for portfolio valuation is the bedrock for effective risk management. In determining fair value of assets at a moment in time, using inputs from the market is critical.
As a result, we have incorporated the impact of market spread movements into the valuation of our portfolio, adjusting for the expected weighted average life and other idiosyncratic factors specific to each investment.
One of our most important jobs is capital allocation, and this cannot occur without marking our assets appropriately. We will continue to follow this framework as we have since inception and we're confident it allows us to make sound investment and risk management decisions based on the market signals.
We've weighed out our framework more extensively in the letter I mentioned earlier. Our investment income reflected a period where our results were driven by the core earnings power of our portfolio with little contribution from activity levels driving other income. 93% of this quarter's total investment income was generated through interest and dividend income compared to 85% across 2021 and 79% across 2020. The anticipated positive asset sensitivity of our portfolio, combined with more normalized activity levels driving other income should further supplement our earnings results for the remainder of the year, providing support for an increase in our base dividend level, which I will discuss in a moment.
Unrealized losses during the quarter resulted in a partial unwind of previously accrued capital gains incentive fees that we have discussed in prior quarters. Given this unwind is tied primarily to unrealized gains from our investments, consistent with how we've treated this line item in prior periods, we've adjusted this quarter's results to exclude the impact of this noncash expense reversal, which was approximately $0.12 per share.
Reported net investment income and net loss per share for Q2 were $0.54 and $0.18, respectively.
Due to the strength of our historical credit performance and generating cumulative net realized gains in excess of unrealized losses, the remaining $0.09 per share of capital gains incentive fee on our balance sheet will continue to provide a cushion to any negative impact of market spread movements on net asset value.
At quarter-end, our net asset value per share declined by approximately 3.4% from $16.84, which includes the impact of the Q1 supplemental dividend, to $16.27. As discussed, the primary driver of this decline was $0.66 per share of unrealized losses from the impact of credit spread widening and lower implied equity values on the valuation of our portfolio.
Note, this approach to incorporate credit spread movements within our valuation framework follows the fair value requirement for BDCs under the Investment Company Act of 1940 and is in accordance with GAAP. Ian will walk through the other drivers of this quarter's net asset value bridge in more detail.
Turning now to a few thoughts on the current market environment. With the possibility of a recession on the horizon, we remain highly focused on our risk management framework to guide our investment and capital allocation decisions. As we address those and other topics in our letter, we'll focus our time today on the impact of rising rates on our income statement.
We expect to see meaningful positive asset sensitivity in the back half of the year. The combination of the rising rates in Q2 are now well above our average floor levels on our debt investments and the shape of the forward LIBOR or SOFR curve support that expectation. The rising rates will drive incremental interest income and outweigh the increases in the cost of our liabilities. To date, this has been largely muted because applicable reference rate resets occurred during -- occurred earlier in the quarter.
Based on the shape of the forward curve and reset dates of our issuers, we project the remainder of this year that rate movement loan will result in approximately $0.13 per share of incremental net investment income purely from the core earnings power of the portfolio relative to what we experienced in Q2. In addition, to the extent we see portfolio growth over this period, the core earnings power of our business will be further enhanced.
In previous periods of rising interest rates, for example, from 2017 to late 2018, the reality of asset sensitivity has been called in question, given the tendency of the BDC sector to sacrifice spread in order to prioritize asset growth. Given the spread environment today, our strong relative capital base and significant liquidity, we are well positioned to retain the asset sensitivity. Ian will provide an update on our full year guidance later on.
While we view the rising rate environment in a positive light with respect to our earnings profile, we are cognizant of the impact more broadly on our borrowers of rising rates, coupled with inflationary pressures on import prices and a more challenging operating environment. As Bo will discuss, despite these rising costs, the overall health of our borrowers' financial position remains strong.
Based on our updated view of forward earnings yesterday, our Board approved the third quarter base dividend of $0.42 per share to shareholders of record as of September 15, payable on September 30. This represents an increase of $0.01 per share to our quarterly base dividend. There were no supplemental dividends declared related to Q2 earnings based on our formulaic supplemental dividend framework, largely due to lower activity-based fees during the quarter, as mentioned earlier. In a spread widening period where valuations experience downward pressure, the NAV limiter in our framework also serves to retain capital and stabilize net asset value.
We would note that following dialogue with and feedback from existing shareholders, our Board approved to change the payment date timing of our quarterly base dividend such that the record date and payment date will occur during the same fiscal quarter. This change has no material impact on our financial results or accelerate the payment of the base dividend by approximately 15 days each quarter relative to our past practice.
With that, I'll now pass it over to Bo to discuss this quarter's investment activity.
Thanks, Josh. I'd like to start by layering on some additional thoughts on the broader market backdrop and more specifically, how it relates to the positioning of our portfolio and the way we're thinking about the current opportunities in the market.
Although we cannot predict the impact, timing or severity of the Fed's actions on the economy, we feel confident that our portfolio is defensively positioned for a couple of important reasons.
First and foremost, we follow a differentiated approach to underwriting, which includes analyzing and understanding, among other things, the unit economics of our portfolio of companies. We are heavily invested in businesses that are characterized by having predominantly variable cost structures, strong recurring revenue attributes, high switching costs and low customer concentration.
We believe these fundamental characteristics will be key in the ongoing inflationary environment as we expect companies with pricing power and variable cost structures will be better positioned than those with large exposure to commodities, high fixed costs and limited ability to pass through price increases.
Secondly, we remain invested at the top of the capital structure with 90% of our portfolio by fair value and first lien loans. In this environment, with market expectations indicating that credit losses are likely to increase, we feel that our positioning at the top of the capital structure in definitive industries will serve to preserve our capital and support our robust return on equity profile.
Our top 2 industry exposures are business services followed by financial services at 14.7% and 11.5% of the portfolio at fair value, respectively. Note that the vast majority of our exposure to financial services are B2B integrated software payment businesses with limited financial leverage and underlying bank regulatory risk.
While we present our industry exposures based on the end market that our borrowers serve, from a broader lens, approximately 81% of our portfolio of companies represent software and services oriented businesses with high levels of recurring revenue and resilient business models.
Retail ABL exposure remained relatively low at 5.9% of our portfolio on a fair value basis at quarter end. However, we expect the inflationary environment and high rate environment will likely create interesting opportunities for us to become more active in the space.
Now I want to spend a moment on how we're viewing investment opportunities and portfolio activity against the current market backdrop. During the quarter, high yield and broadly syndicated loan markets were mostly on the sidelines given the environment. Although liquid markets were quick to react, the private markets have been much slower to reprice and largely remain in a period of price discovery between buyers and sellers in terms of valuation. We anticipate there will be more opportunities to provide direct lending solutions as sponsors remain active in looking to deploy capital as well as privately held companies looking to bolster their balance sheets.
Our omnichannel approach to sourcing is critical in driving these opportunities. With the potential for increased deal flow in the second half of 2022, we continue to be very selective with our investment opportunities and have set a high bar for allocating our capital during this period. As we've said in the past, our primary priority is generating attractive risk-adjusted returns for our shareholders, which requires us to be disciplined in our approach to deploying capital.
As it relates to the portfolio activity, we had $379 million of commitments and $325 million of fundings across 8 new investments and upsizes to 2 existing portfolio of companies during the quarter. Consistent with our focus on maintaining a defensive portfolio, our 2 largest investments, CrunchTime and Merative, were in software services companies with deeply embedded underlying products, resulting in high-quality recurring revenue basis.
CrunchTime was a first lien term loan where our relationship with the company from a previous successful investment that we exited in 2017 allowed us to act quickly to support the acquisition of Zenput, a highly complementary business to CrunchTime's enterprise management solutions.
As for our investment in Merative, formerly known as IBM Watson's Healthcare business, we partnered with Francisco Partners to provide a funding for a complex transaction involving the carve-out of certain software assets. We leveraged the power of the Sixth Street platform as well as our deep relationship with the sponsor to provide a financing in the form of a senior secured credit facility to support the acquisition and carve-out with speed and certainty of execution. Both of these investments follow our thematic approach of underwriting the underlying sectors and industries that we believe are defensive and stable in the current environment.
Notably, although we only closed the Merative transaction at the end of June, pricing in terms of this transaction were agreed to back in February, and it was of that date that becomes a reference date for determining the impact of spread movements through the end of Q2. While there's been no deterioration in performance, that approach has resulted in an unrealized loss on the name of the loan for a fair value determination of approximately $0.02 per share in Q2.
Other new investments during the quarter include several new deals and upsizes to existing portfolio of companies such as Staples as well as investment in the energy space to merchants in oil and gas, which increased our energy exposure to 3.2% of our portfolio on a fair value basis as of the quarter end.
Similar to prior periods of market volatility, we made purchases of BB and BBB CLO liabilities, which comprise approximately $29 million of fundings during the quarter. As one of our core opportunistic investment themes, at certain moments in time, these investments present an efficient use of capital on their return profile. We purchased these securities at a significant discount to par with a yield to 3-year recovery of approximately 12.5% with significant subordination to protect against future credit losses. We believe our expertise in the structured credit market further highlights the benefit of the broader Sixth Street platform in terms of providing TSLX with differentiated deployment opportunities especially in times of market dislocation.
Moving on to the repayment side, there were $212 million of paydowns across 6 full and 1 partial investment realization. Of the 6 full repayments, 2 were paydowns driven by refinancings, which we participated in, thereby offsetting the paydown with subsequent new fundings during the quarter. Although the repayment activity in Q2 was in line with historical averages, the vast majority of our paydowns occurred during the first month of the quarter. As spreads widened more meaningful in the back half of Q2, we saw a slowdown in repayments resulting in lower activity-based fees.
For reference, 65% of repayment activity during the quarter occurred in April. Our largest payoff, Illuminate, occurred on April 1 and represented 30% of total repayment activity. This investment generated an 11.5% IRR and a 1.5x MOM during the whole period of 4.6 years, reflecting the older vintage nature of the payoffs in Q2 resulted in limited OID in the quarter's net investment income.
Supporting the performance of our portfolio this quarter was the announcement on May 10 of Pfizer acquiring all the outstanding shares of Biohaven. Our weighted average mark on Biohaven increased from 104% to 111% during the quarter, reflecting the impact of the anticipated fees embedded in our underlying exposure to the portfolio of companies.
While incorporated in the Q2 fair value mark, the expected fees will eventually flow through investment income at the time of payoff, resulting in the crystallization of activity-related fees increasing our capital base and creating incremental investment capacity for new deployment opportunities.
Our weighted average yield on debt and income-producing securities at amortized cost was up to 10.9% from 10.3% quarter-over-quarter and is up about 80 basis points from a year ago. The weighted average yield at amortized cost on new investments, including upsizes this quarter, was 10.1% compared to a yield of 9.5% on exited investments.
Moving on to the portfolio composition and credit stats. Across our core borrowers for whom these metrics are relevant, we continue to have conservative weighted average attach and detach points on our loans of 0.8x and 4.6x respectively, and their weighted average interest coverage remained relatively stable at 2.6x.
As of Q2 2022, the weighted average revenue and EBITDA of our core portfolio of companies was $140 million and $34 million, respectively. The performance rating on our portfolio continues to be strong with a weighted average rating of 1.13 on a scale of 1 to 5 with 1 being the strongest, representing no change from the prior quarter.
We continue to have minimal nonaccruals at less than 0.01% of the portfolio at fair value with no new names added to nonaccrual during Q2. The stability of these metrics quarter-over-quarter illustrates there has been no deterioration in the underlying credit quality of our portfolio.
While historical data is important, we recognize what really matters is future performance. We believe we've done a good job positioning our portfolio to date, but as always, time will tell.
Finally, the strong pipeline that we referenced during our last earnings call continues to provide us with attractive deployment opportunities. Given our strong liquidity and capital position, that is true to be a competitive advantage relative to peers that operated with higher levels of financial leverage. We expect this aspect to extend in the current period of volatility as access to capital may become more constrained.
With that, I'd like to turn it over to Ian to cover our financial performance in more detail.
Thank you, Bo. For Q2, we generated adjusted net investment income per share of $0.42 and adjusted net loss per share of $0.30.
At quarter end, total investments were $2.5 billion, up slightly from the prior quarter as a result of net funding activity, partially offset by the impact of lower valuation marks on our portfolio.
Total principal debt outstanding at quarter end was $1.3 billion and net assets were $1.2 billion or $16.27 per share. Our average debt-to-equity ratio decreased slightly quarter-over-quarter from 0.95x to 0.9x, and our debt-to-equity ratio at June 30 was 1.06x, up from 0.91x at March 31. The decrease in our average debt-to-equity ratio was driven by repayment activity in the beginning of the quarter, with leverage dropping to a low of 0.86x in April.
As Bo mentioned, we saw a pause in repayments in the latter half of and increased fundings during the last few weeks of the quarter, resulting in a higher reported leverage metric at June 30. More specifically, net funding activity in isolation would have resulted in a leverage ratio of 1.02x at quarter end, with the delta to our reported quarter end figure of 1.06x being the impact of valuation marks on our investment portfolio.
Before turning to our results, I would like to reiterate the strength of our liquidity, funding profile and capital position. At quarter end, we had $1.2 billion of undrawn capacity on our revolving credit facility against only $155 million of unfunded portfolio of company commitments available to be drawn based on contractual requirements in the underlying loan agreements.
In addition to having significant liquidity, we remain well below the top end of our previously stated target leverage of 1.25x, providing us with the ability to capitalize on attractive investment opportunities for our shareholders. We believe this combination of liquidity and our capital position, which proved its value and importance during the pandemic, positions us well across varying operating scenarios and enhances our competitive positioning. Our capital allocation framework remains top of mind for us as well given current market dynamics, and we've elaborated on this subject in our letter.
As it relates to our debt maturity profile and any impact on liquidity, the remaining principal value of our convertible notes settled on Monday, August 1, with no material impact on our liquidity. As mentioned in prior quarters, earlier this year, we elected to settle the converts primarily with stock, resulting in an equity issuance earlier this week of approximately 4.4 million shares. Close to 80% of the outstanding principal amount was settled in stock and the corresponding equity issuance translated to approximately $0.08 per share of accretion to our net asset value, which will be reflected in our Q3 financial results. This transaction improved our capital positioning by lowering our leverage ratio and increasing our capital base, thereby creating additional capacity to invest in interesting new opportunities as they arise.
Quarter-to-date, our net funding of new investments amounts to approximately $145 million. Pro forma for the settlement of these convertible notes early this week and inclusive of the impact of net fundings and broad market credit spread tightening of approximately 50 basis points since quarter end, we estimate our current leverage is 1.04x, with liquidity of approximately $1 billion. After the settlement of these convertible notes, our funding mix is comprised of 57% unsecured debt and 43% secured debt.
Moving to our presentation materials. Slide 8 contains this quarter's NAV bridge. As Josh mentioned, the impact of credit spread widening on the valuation of our portfolio was by far the most significant driver of NAV movement this quarter with unrealized losses of $0.66 per share. Again, absent permanent credit losses, we would expect to see a reversal of these unrealized losses related to credit spreads over time as our investments approach their respective maturities.
The estimated impact of broad market credit spread tightening since quarter end that I referenced earlier represents approximately $0.16 per share unwind of the unrealized losses we saw during Q2.
Walking through the other drivers of NAV movement this quarter, we added $0.42 per share from net investment income against the base dividend of $0.41 per share. There was a $0.12 per share uplift to NAV related to the unwind of previously accrued capital gains incentive fees, which Josh also mentioned earlier. And finally, there was a $0.04 per share decline in NAV from the unwind of unrealized gains as a result of paydowns.
Moving on to our operating results detail on Slide 9. Total investment income for the quarter was $63.9 million compared to $67.4 million in the prior quarter.
Walking through the components of income, interest and dividend income was $59.1 million, up slightly from the prior quarter, driven by net funding activity during Q2. Other fees, representing prepayment fees and accelerated amortization of upfront fees from unscheduled paydowns, were lower at $3.2 million compared to $6.9 million in Q1, given the lower impact on income measures from repayment activity that we highlighted earlier. Other income was $1.6 million compared to $1.8 million in the prior quarter.
Net expenses, excluding the impact of noncash accrual related to capital gains incentive fees, were $31.4 million, up approximately 5% from prior quarter. The increase in net expenses quarter-over-quarter was primarily driven by the upward movement in reference rates, which increased our weighted average interest rate on average debt outstanding from 2.3% to 3.1%.
There is a lag to the impact of rising interest rates on the weighted average interest rate on average debt outstanding and the increase this quarter is largely explained by the movement in base rates from the prior quarter.
Before I discuss our guidance for the remainder of the year, noting for those that track this metric, as of the end of the quarter, we estimate that our spillover income per share is approximately $0.56. Year-to-date, through June 30, we have generated adjusted net investment income per share of $0.90, corresponding to an annualized return on equity of 11%. This compares to the target return on equity that we have articulated throughout 2022 of 11% to 11.5% or $1.84 to $1.92 on a per share basis.
Based on the impact of the positive asset sensitivity in our business that Josh referred to earlier, resulting in higher anticipated net investment income combined with the strong overall health of our portfolio, we expect to exceed the top end of our target range for full year 2022.
With that, I'd like to turn it back to Josh for concluding remarks.
Thanks, Ian. We hope people take the time to read our letter, as we outline what we really think matters in driving shareholder returns. Brevity isn't of our strengths. We apologize in advance. With a clear understanding of what is important in driving the results of our business, we will continue to create value for our stakeholders and serve our portfolio of companies, management teams and financial sponsor partners with creative financing solutions.
In closing, I want to wish everyone a wonderful rest of the summer with their friends and loved ones.
With that, thank you for your time today. Operator, please open up the line for questions.
[Operator Instructions]. Our first question comes from the line of Finian O'Shea with Wells Fargo.
Can you tell us about the new BDC Sixth Street has on file? Would it fall within the same origination line as Sixth Street has on file? Would it fall within the same origination line as TSLX? And -- or otherwise, how would the investment style compare?
Look, we're obviously limited on what we can talk about given the private placement rules. What I would say is it's a completely different investment strategy than Sixth Street Specialty Lending and so there should be limited overlap. And what we -- as you know, for the last 10 years, I guess, 12 years since we formed Sixth Street Specialty Lending, the sole focus and our continued focus will be on creating shareholder returns.
Obviously, the direct lending market has opened up significantly. And there are areas in that market given the TSLX's capital base and our unwillingness to raise equity all the time that we can't be involved in. But given the private placement rules, it's hard to talk about at this moment. But I assure you that it will have no impact on Sixth Street Specialty Lending's focus or cannibalize its opportunity set in any way.
Okay. That's helpful. As a follow-up, one of your BDC peers yesterday lowered its base fee to accrue on NAV essentially instead of assets this week. Seeing if you have any sort of initial thoughts on that, what it might mean for the industry, how you think about it?
Look, I can say a lot of snarky things, and I'll try not to say snarky things.
One is, I think that peer had a long history of problems on the performance side and also change investment strategy over time. I think when you look at the yield on their investments and you think about just the simple portfolio minus the fee, I think their debt investment portfolio is like a 7.7% yield. They're effective fee now given NAV is like 70 basis points. And so their net yield prior to leverage and prior to incentive fees is like 7%, right, and other costs. When you look at the SLF portfolio, I think our yield in amortized cost in is...
10.9%.
10.9%. Doing the same math, adjusted for 1.5%, that gets you to...
9.4%.
9.4%. So we're still 240 basis points higher prior to accounting for skills related to credit loss and quite frankly, that we're running -- and we're generating return on equity, I think, pro forma significantly higher and using less financial leverage to do so.
So I -- look, they have had a change of strategy over time. They put a whole bunch of thread compression in their book and they had performance issues on the credit side. So it's not shocking, but it might be appropriate for that strategy.
And then the last thing I would say is I was a little confused about the purchase at NAV given that the stock price is way below NAV. And as I understand, the affiliate is owned by other people, too. So that was a little confusing, but I'm sure there was reasons to do that.
Our next question comes from the line of Mickey Schleien with Ladenburg.
Good morning, everyone. Josh, in the prepared remarks, I think I understood that you said your fee income or you expect your fee income to be -- to improve in the second half of the year. Could you just help us reconcile that against a rising rate environment? Because typically, we would expect rising rates to limit prepayments.
And as a follow-up to the question, why were fee -- why was fee income a little light this quarter relative to historical levels?
Yes. So first of all, I think we don't run a mortgage book. So I think that's true in mortgage when I think it spreads in that matter. So -- but your point is taking -- if you think about widening spreads, we don't have a rate sensitive book compared to prepayments. We have a spread sensitive book compared to prepayments.
And so obviously, spreads were out. Borrowers have access to -- they have spreads that they don't want to opportunistically refi and valuations and public valuations for private sellers of buyers and sellers of private businesses, it needs time to figure out new valuation.
So I would say two things on the forward. One is even though spreads are widening, we expect M&A to increase over time. And so some of our portfolio will ultimately churn, but there's this period in the private markets where that doesn't happen, given the valuation disconnect.
And then the other item, which is I think is clear and been announced, is that Biohaven -- and I'm not part of that management team and part of the acquirer, which I think is Pfizer, I don't want to speak to the timing of that. But that's a change of control of transaction and there's significant call protection in that. And so that will be rolling through, I don't know if it's Q4 or whatever, back half, but it's going to be most definitely rolling through.
And so I think the combination of that -- we expect M&A markets to thaw, they didn't thaw in Q2 as M&A markets thaw. And there are people, certain buyers and sellers see eye to eye, portfolio churn will increase a little bit. And then we can look in our book and look at the idiosyncratic things such as Biohaven that we have visibility into.
I appreciate that. And I understand. Josh, one last question. If we look at the leveraged loan market sort of as an indicator of where defaults might go, the distressed ratio is a little north of 3%. Looking at your crystal ball out for the rest of this year and going into next year, do you expect defaults to climb to those levels? And how do you expect your portfolio to behave in terms of credit given the trends that we're seeing in the economy?
Mickey, you hit it head on, which is I think if people read our letter, what we've said is there is no free ride, broad-based free ride. We think our portfolio behaves differently on rising rates. Rising rates will lead to a default cycle, especially if you believe we're in some stagflationary environment where there's inflation, but very low growth. And if you look at credit spreads as a proxy, credit spreads are telling you that the return needed to extend credit should be higher given perspective defaults and losses.
So I think -- I don't have a crystal ball on what that number is. But there's a whole bunch of ways to do the math. And if you think that historically, the average single B has had a net spread post losses of 200 and 250 basis points, you can look at the prior losses going forward given spreads. There's a whole bunch of ways to do the math. But directionally, I think most definitely defaults and losses are going to increase and investors in the space, in the BDC space can only net investment income less realized losses. So I think that's really important.
The second thing is our portfolio is really defensive. Top of the capital structure, I think 80% was in the prepared remarks of basically business, service and software, whether it's recurring revenue and variable cost structure, and really no inputs that would lead to inflation.
And so I think we feel really good and quite frankly, pricing power. And so I think we feel really good about where our portfolio is headed. In addition to all those things and attributes, why those -- why they have those attributes like pricing power is because they're solving problems for -- our portfolio of companies are solving problems for their customers that are real and valuable to them.
If you look at our portfolio, I think year-over-year portfolio growth was about 31%. Quarter-over-quarter was about 7.2%, so 28% annualized. So you're surely -- you're still strong portfolio growth, still revenue growth in our portfolio of companies, in our core portfolio of companies, although it is clearly decelerating, but our portfolio of companies have much more levers on the cost side given their variable cost nature.
So I feel pretty good about our portfolio. I feel pretty good about the forward earnings power of our business given the inflection on rising rates. And so I'm positive and quite frankly, we have a whole bunch of embedded earnings power in our business, given that we have more capital, more liquidity in the space to take advantage of a better lending environment. So I'm excited.
I appreciate that, Josh. Thanks for all the transparency. We certainly appreciate it very much.
Thanks, Mickey.
Our next question comes from the line of Kevin Fultz with JMP Securities.
You touched on this a bit in Mickey's question. Clearly, portfolio credit quality is in excellent shape with nonaccruals at cost of 0.1%. Just curious from where you sit, Josh, and how you think about things, are there certain verticals that you see as more at risk in the current environment, whether that's due to inflation, labor issues, geopolitical risk or recession fears that you're monitoring more closely as the macro environment continues to evolve?
Yes. So it's a great question. So yes, I mean, we're very positive on our portfolio. And look, we've been thoughtful about how we've built that portfolio and the characteristics of those companies and where we invest in the capital structure.
If you take a giant step back and of what's happening in the world today, the policymakers have to get inflation under control. The only way to get inflation under control is effectively to kill the consumer, unfortunately. And part of killing the consumer is a restrictive monetary policy, which takes dollars out of their pocket and also increasing the cost of capital to companies for them to make investment decisions and hiring decisions, et cetera.
So you can expect that employment -- unemployment is going to rise, the consumer is going to get in worse shape. I think I saw a headline yesterday where consumer debt's up and credit card debt's up, et cetera.
So I think we're in a really tricky environment. The question is, can the Fed get to a soft landing where they can kill the consumer enough to land ahead, to the land the plane on the proverbial head of a needle but not kill the economy. And I think the market is kind of trying to figure that out.
Our portfolio generally is a B2B portfolio. And so we don't have a whole bunch of consumer. We don't have any retail outside of ABL. We don't have any -- we don't have -- the cost structure of our business don't have a whole bunch of commodity inputs that have been -- that have inflation where they can't price on, but they can't -- we don't have those -- that nature of that portfolio of company where there's commodities in the cost structure.
So I would be aware of low-margin businesses that have -- measured by EBITDA margins or EBIT margins that have commodity inputs or those businesses that are affected by inflation, they probably don't have pricing power. And those businesses that have or around consumers I think are going to be challenged going forward, too, as well.
So I feel relatively good about, again, the portfolio positioning. But look, the -- our world and the economy is very interconnected. I tried to talk about this in our letter. And B2B is going to be affected, too. But most definitely, I think we have a more insulated defensive portfolio.
Our next question comes from the line of Kenneth Lee with RBC Capital Markets.
Just one on the CLO investments you mentioned. You talked about it being an efficient use of capital. Just wondering whether you could just further flesh out how these investments compare with your more traditional debt investments? And as well, how do you think about the risks, especially under potential macro deterioration compared with most of your other debt investments?
Yes. Yes. It's a great question. So first of all, we've had this strategy in place over time. I think we invested in a bunch in '15, '16. We did it in COVID. I think we might have done it in '18, '19 when there was a market blip where a lot of the -- there's a lot of forced selling coming out of those markets because they're held by mutual funds. And so people have to be force sellers.
When you look at the loss-taking ability in those securities, you have to think that broadly syndicated loan default rates are very, very high and stay high for a long time. And so you have less idiosyncratic kind of insight, although we go portfolio by portfolio, look at the underlying names, although the underlying names can change if they're in the early investment period.
But historically, when you look at -- so they have greater loss-taking ability around defaults, although not on an idiosyncratic basis. And when you look at the private loans usually had offered about a 400 basis point premium to BBs and a 200 basis point premium -- sorry, a 400 basis premium to BBBs and a 200 basis point premium to BBs. And when you look at the environment that we've been in, that environment is now -- the spread premium was flat to negative 300 basis points. And so the relative value was really, really wide and the yield of recoveries were in the kind of low teens. And so we just think it's a much more efficient use of our capital, and quite frankly, it's also a source of liquidity unlike private loans, which can never be a source of liquidity.
So we like that. We've done it. We have a team that is focused on it, and we think we have unique insights and -- so again, we're focused on efficiently using our shareholders' capital to create total returns, both on a spread basis and on a capital appreciation basis. And you can buy a BBB security at 90 or 89 with a lot of loss-taking ability where the world would have to end if it was ever in default. And I think we'll start with defaults have been -- forward losses have been 0 and BBBs, again, with 10-point of OID and with -- as good a spread. It just seems like a no-brainer.
Got you. Very helpful there. One follow-up, if I may, just on the valuation changes. It sounds like from the prepared remarks, a lot of it was mainly spread-driven. Wondering how much did the idiosyncratic factors drive some of the fair value changes within the portfolio?
Yes. So I would them in, really, two categories. And the two categories being broad-based spread movements. And then as you know, we have a small equity book and equity premiums, risk premiums widen as well.
So there wasn't really any performance-based markdowns broadly in the book. The book is performing. It's a combination of on the equity instruments we hold, valuations came down. Now -- and kind of if you think about corporate finance, they should earn, they should generate a return from a go-forward basis from the trough valuation, but it's less visible because equities have longer duration and don't have a maturity.
And then the other bucket is the credit spread where it is, quite frankly, if we're right on credit, all those stood -- all the unrealized losses that went through the books should actually unwind because at some point, we will get our par back at maturity or before maturity, so those should all unwind.
So there is not really any broad-based performance markdowns in the book. It was a combination of spreads widening and on our equity book, equity valuations came down.
Our next question comes from the line of Robert Dodd with Raymond James.
Thanks for the color on the NAV and the letter, I really think that's quite interesting. On -- not on that topic. When you look at -- historically, you have generated a lot of income from fee structures, a lot of call protection in the way you structure loans, et cetera. Maybe not in this environment, but over the next couple of years, do you expect any pushback from borrowers on the amount of kind of core protection you embed given how competitive the private credit market is increasingly going? Or is it a case of, frankly, the borrower doesn't care that much because the call protection is usually paid by an acquirer in an M&A event?
Cool. I'm not sure the call protection is made by the acquirer in an M&A event. It comes out of the seller proceeds. So put that -- I -- so I put that in, that's the seller's capital structure. They bear the cost of the capital structure.
I would say first of all, I think the premise of that the competitive environment, I think, is changing significantly or on the margin significantly more than we've seen historically, which is I don't know if it's lack of retail flows in the products or people being at the top end of their leverage. And so there's less capital.
But we have seen spreads increase. We saw it at the end of the quarter, that's what we reflected in our book, along with broadly syndicated loans. And we're seeing it now. And so we're really seeing reinvestment spreads increase. And so the world -- and we're seeing fees go up and we're seeing leverage go down.
And so the world is becoming a better kind of a better place for lenders. My guess is it is also becoming a better place for buyers on the private equity side because they're buying at lower valuations. And so I think, generally, I think terms are being more lender-friendly and sellers are getting -- buyers are getting better terms given the change in the valuation environment.
The one I would say is when you look at kind of the proxy for how much think how much NAV increase is embedded in our book. The metric that we post that you should look at is fair value of the portfolio related to call protection because that tells you if the book looked weight date today, how much is rolling through either the unrealized-realized gains section and how much and some of that will roll through the investment income line.
This quarter, I think is -- and part of this is because the markdown, it was 94.1%. So last quarter, it was 95.1%. And so when you look at our book as it relates to where people are creating it as a percentage of call price, it's the cheapest it's been at least in the last 5 quarters I've been looking at it.
Got it. Got it. And I do look at that line. I mean what -- obviously, that, to a degree, the call protection goes -- not to a degree. I mean, it goes down over time as assets age, in many cases. So I mean, have you changed anything on the -- your probability weight call protection, et cetera, when you're coming up with fair values et cetera, is there any shifting change on that piece of the framework in terms of...
That was the (inaudible) we like. Sorry, when we've come up with fair value -- sorry, or I think your question was that have we changed the -- when you look at our fair value of investments, effectively, has the weighted average life of our book increased a little bit. And therefore, the probability of call protection has decreased because call protection is a melting ice cube. I think that was the question, just I want to make sure I got the question.
Yes.
Yes, I think the answer is yes on the margin. Given the wider spread environment, the weighted average life has most definitely increased a little bit.
Our next question comes from the line of Melissa Wedel with JPMorgan.
I'll reiterate prior comments about just appreciating the shareholder letter that you guys posted with a lot of detail about how you're thinking about the environment.
I wanted to follow up on a comment you made earlier about sort of expecting an elevated pipeline perhaps in the second half. And I wanted to touch on that a little bit more. Do you think it would be fair to say that given the rate environment, a lot of companies wouldn't necessarily want to be in the market in the second half unless they had to? So perhaps the pipeline might be a little bit more stressed than what we've seen in the first half? And if so, how you're mitigating that?
Yes. So Look, I think it's really interesting because -- and Bo should comment on this. The -- there's a ton of private equity dry powder. So people are -- there are buyers that are willing to transact and we're seeing that. If you look at first quarter net fundings was $150 million. So whatever excess -- Ian, correct me if I'm right. Not first quarter, this Q3 quarter to date...
Quarter to date, yes. July basically.
July was $150 million. So that tells you about the demand for credit on the M&A side. That historically relates to net fundings on average between $50 million and $75 million, I think. On the net plan, we're already up $150 million July to date. We've already used -- effectively we used -- if we ended the quarter at 1.01x approximately debt to equity, we're 1x debt to equity after the converts. So we've used capital. And when you look at -- I don't think there's -- we've been -- I think we've probably been -- we're busier now than we were in the last 12 months.
And so you're having a combination of there is a whole bunch of private equity dry power in the system. And you've now had time where buyers and sellers start seeing eye to eye on valuation, where sellers don't say to themselves, oh, in their mind, I'm going to buy the dip, things are going to change. They've now started to capitulate a little bit. Public companies are capitulating on big take privates. And there is capital out there on the private equity side. So -- and lending terms are getting better and valuation terms for the buyers are getting better. And so it kind of all works.
So I'm pretty bullish about the opportunities set going forward, and we're positioned with at the low end of our target debt to equity, and we're positioned at the low end of the space. We have more capital, more liquidity than the rest of the space.
I mean, I think one competitor who was at 1.5x debt-to-equity who cut their fees, who have a different strategy. I think they're -- was at 1.26. And so we're -- we have relatively more capital, more liquidity for our balance sheet than the space. And so I'm jazzed about the forward with wider spreads and a higher base rate environment and a high-quality portfolio.
And so Bo, I don't know if you have anything to add. I think it took all your thunder.
You took all of it. But yes, the only thing I would add is that, look, we'll see a lot of opportunistic M&A, and we're seeing that. The pipeline is as busy as it has been in quite some time with opportunistic M&A both from the private equity world that are seeing values that have come down and also from the corporate world where the best businesses are actually bolstering their balance sheets to be on the offensive.
And then lastly, equity markets have been very cheap over the last in 3 to 5 years. And good businesses are now turning to the credit markets to bolster their balance sheets versus raising very cheap equity. So that combination has us quite bullish on the opportunity set in the second half of the year, combined with a much more favorable lending environment where we're seeing leverage come in, pricing and fees go up.
Yes, I fully -- completely got them. You actually hit it better than I did.
All very helpful. So I appreciate that. And then to follow up on it, given the bullishness of the team and the capacity that you have from a leverage standpoint, just want to clarify like where you would -- you would be comfortable taking leverage -- portfolio leverage up to sort of the higher end of that target range into this environment, given sort of greater macro risk, but also want to clarify, one, is that the case? And two, how are you thinking about leverage? Is that sort of on balance sheet? Or is that also inclusive of the undrawn commitments which you also touched on in that shareholder letter?
Yes. It's a really great question, complicated question. So I don't think we're going to take it up to -- what I would tell you is I don't think we're never going to take it up to 1.5x.
The way we think about our balance sheet is we reserve on front-funding commitments. We reserve it to make -- this is on the capital side. Some of this is applicable to the liquidity side, too. We reserve front-funding commitments because that reduces our capital when those get funded, it increases their leverage. We reserve for a credit spread widening because that reduces our capital on a mark-to-market basis. And we would like to have dry powder to make investments in our capital structure and make new investments.
And so if that's 1.15 to 1.2, it's kind of in that range, but it's a moving target because it's a function of unfunding commitments that we have as well, given that we have to burden our capital and burden the liquidity for that.
If you look at our business and you take a step back and you say, what is the constraint in our business? Is it capital or is it liquidity, the constraint is capital. Or not capital constraints, so don't read it that way. But like we have -- if we have more liquidity given our financial policies than we do capital on the margin, so it's kind of in that range.
But it's a moving target. And in times like today, we run balance sheets daily or weekly and overlay or forward pipeline. And we're pretty thoughtful about how we put our capital to work and understanding our own cost of capital because I think that's the path to shareholder value creation.
Our next question comes from the line of Ryan Lynch with KBW.
First question I had was you mentioned the investments you made in some CLOs in the quarter, kind of a two-parter on that. One, is that opportunity set still exist in the marketplace today? And then also, it sounds like you're seeing a ton of opportunities just in the private markets. But are there with the dislocations we've seen in kind of the liquid markets, which obviously contributed to the opportunities in the CLO markets. Are you seeing any direct opportunities to invest in any secondary positions, whether that's any sort of leverage loans or high-yield bonds in this marketplace? Or is it just limited right now to CLOs?
Yes. So I think the 630 was kind of the low point on CLOs. And I think we were flat basically on those purchases during the quarter and then things have come up on prices 2 to 3 points or something like that. So we haven't made any additional purchases.
And then as it relates to secondary purchases of names, we're most definitely looking. I don't think they offer a strong relative value as the CLOs do -- or again, this is not CLO equity. This is not like first loss in the capital structure. This is where there's protection against losses in the structure.
And then on the margin, all things being equal, when you think about kind of how we would like to use our capital, we like to use our capital to support our clients if it makes sense on a relative value basis. So like when I think about the pecking order, I actually think about if we're getting paid enough, I'd rather than do it in private loans because that's our business and we like to support of clients. And then if we're going to do liquid stuff, I start looking at relative value. And again, the relative value seemed like a no-brainer at that moment of time. And we've done this over history, and we've done a pretty good job of it.
So -- but on the margin, I'd rather use our capital to support our clients. But we have most definitely looked at probably syndicated loans and -- high yield is tougher for us just because you're making an implicit rate that -- and they're longer duration -- though I'll say we generally like about private credit, the last thing I'll say is that does have a shorter weight of average life. And so your spread per weighted average life, if you think about that metric is, very attractive versus high yield, your discount margin, the weighted average life is less attractive. So -- and probably syndicated loans as well, they're kind of set up so they don't have to talk to their lenders.
Okay. Understood. The other one that I had was you mentioned a lot about your portfolio of companies having variable cost structures. Can you explain what that is exactly? I'm not sure if you're referring to maybe your software businesses, and I would assume if that's the case, maybe it's more like sales and marketing, they can make a toggle on and off. But I'm just curious, what is the variable nature of the cost structures that they can kind of toggle?
Bingo. Yes, you hit it.
Okay. And then just one clarification just from Ian just to make sure. The commentary you gave with a $0.13 of additional earnings in the second half of 2022, given the shape of -- and where LIBOR is today and kind of the curve of LIBOR, SOFR, I just want to be clear, that is the cumulative amount that you guys would expect over the second half of 2022. And I would assume that, that would be kind of -- that would build throughout the last 2 quarters, so $0.13 in total, just a rough estimate, you could say like $0.05 in Q3 and $0.08 for Q4 or something like...
$0.05 and $0.08. Yes. You're spot on, Brian, $0.05 and $0.08.
Ryan, the way to think about it is the effect of LIBOR in our book this past quarter -- weighted average effect of LIBOR was like 107. We had no asset -- we had -- which was right above our floors. We had very little asset sensitivity in our book.
I think on a bottoms-up basis, people can correct me if I'm wrong, we went reset by reset. And on a bottoms-up basis, we're at like 190 in Q -- 190, well, if everybody reset at the end of Q2, we would be at 190. The -- and then it goes up from there. So we kind of looked at it as on -- and that kind of flips to our asset sensitivity table in the Q, you have to adjust for the incentive fee because that's just on a net -- on a net investment income less interest cost basis. So you have to adjust for the incentive fee. But it is -- the book is about given the resets and we're through the floors, the book is about to take off.
Yes. Okay. That makes sense. I appreciate you for taking my questions and I really appreciate the details you gave in your shareholder letter.
I'm showing no further questions in the queue. I would now like to turn the call back over to Josh Easterly for closing remarks.
Great. Thank you so much. Thank you for the questions. Thank you for the time for reading a 10-page letter or 12-page. Hopefully you didn't read the disclosures. But -- although those are important as our Board would remind me.
We really appreciate it. I hope everybody has a great rest of the summer and a Labor Day with their family. And we're around in the fall. And as I keep saying, we're back in the office full time. So please feel free to come visit and we look at getting back on the road. And I think the nice thing of where we are, hopefully, with a little bit post pandemic as we're getting out and seeing shareholders and other stakeholders and portfolio of companies and sponsors. And so we're back out on the road and welcome people in our office. Thank you so much.
Thank you.
Thanks, everybody.
Ladies and gentlemen, this concludes today's call. Thank you for your participation. You may now disconnect.