Sixth Street Specialty Lending Inc
NYSE:TSLX
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Sixth Street Specialty Lending Inc
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Good morning and welcome to TPG Specialty Lending, Inc.’s September 30, 2019 Quarterly Earnings Conference Call. Before we begin today’s call, I would like to remind our listeners that remarks made during the call may contain forward-looking statements. Statements other than statements of historical facts made during this call may constitute forward-looking statements and are not guarantees of future performance or results and involve a number of risks and uncertainties.
Actual results may differ materially from those in the forward-looking statements. As a result of a number of factors, including those described from time to time in TPG 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, the company issued its earnings press release for the third quarter ended September 30, 2019 and posted a presentation to the Investor Resources section of its website, www.tpgspecialtylending.com. The presentation should be reviewed in conjunction with the company’s Form 10-Q filed yesterday with the SEC.
TPG Specialty Lending, Inc.’s earnings release is also available on the company’s website under the Investor Resources Section. Unless noted otherwise, all performance figures mentioned in today’s prepared remarks are as of and for the third quarter ended September 30, 2019. 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 TPG Specialty Lending, Inc.
Thank you. Good morning, everyone, and welcome to our third quarter earnings conference call. Joining me today is my partner and our President, Bo Stanley; and our CFO, Ian Simmonds. I’ll start this morning with an overview of our quarterly results and then hand it off to Bo to discuss origination and portfolio metrics. Ian will review our financial results in more detail, and I will wrap up with some concluding remarks before opening the call to Q&A.
After market closed yesterday, we reported strong third quarter results with net investment income and net income per share of $0.55 and $0.46 respectively. This corresponds to an annualized return on equity base on net investment income of 13.3% and net income of 11%. Our net investment income this quarter was supported by strong prepayment activity and the difference between this quarter’s net investment income and net income was primarily driving by reversal of unrealized gains from investment realizations.
As discussed on our last call, our prior quarter's net income of $0.72 per share included a contribution from unrealized gains from investments where we had visibility on earning contractual prepayment fees. As some of these investments were realized this quarter, we recognized fees to net investment income and unwound previous unrealized gains.
Reported net asset value for the quarter reached another high of $16.72 per share, representing an $0.08 per share increased from prior quarter's net asset value after, including the impact of the Q2 supplemental dividend. Yesterday, our board declared a Q3 supplemental dividend of $0.08 per share to shareholders of record as of November 29 payable on December 31. Our board also announced a fourth quarter base dividend of $0.39 per share to shareholders of record as of December 13, payable on January 15.
Year-to-date, we’ve declared $1.30 per share in total dividends to our shareholders related to earnings in 2019, which represents an 11% increase over our base dividend level. During this time, we’ve also increased net asset value per share by 3.2%. We continue to evaluate our dividend policy to ensure satisfaction with the requirements, while preserving the stability of our net asset value.
As we look ahead, we’ve been proactively strengthening our balance sheet by staggering the maturity of our debt obligations expanding the diversity of our financing sources and increasing our available liquidity. Over the course of this year, we’ve extended the maturity and increased the commencement under revolving credit facility, and post quarter-end we issued 300 million of five-year unsecured notes, which Ian will discuss in more detail.
Let me now transition to a quick observation on credit risk spreads and its impact on evaluation of our portfolio. During the third quarter, uncertainty over U.S. trade policy and global growth led to abbreviated periods of market volatility. Quarter-over-quarter LCD, first lien, and second lien spreads each widened by 20 basis points and 90 basis points respectively. A closer look however shows that credit spread movement was bifurcated on various underlying factors, including cyclical versus non-cyclical industry.
LCD spreads for noncyclical industries on average tightened during the quarter, while they also was true for cyclical industries. Given the low cyclical exposure of portfolio, which stood at 3.2% on a fair value basis at quarter-end, excluding energy – and 8% including energy, the impact of credit spreads moving on the valuation of our portfolio this quarter was relatively needed once we took an account industry specific comps for each of our investments.
Before passing over to Bo, I would like to comment on a recent development for one of our portfolio companies Ferrellgas. This October, the company disclosed in its 10-K filing that it is currently [indiscernible] as the agent on a senior secured credit facility regarding various technical defaults, including the going concern qualification and the company's most recent other financial statements report. We continue to work closely with the management on finding a solution.
With that, I’ll turn the call over to Bo to walk you through our portfolio activity.
Thanks, Josh. Following last quarter's records origination activity, we again posted strong quarterly results with $616 million of gross originations, $356 million of commitments, and $309 million of fundings. Q3 fundings were distributed across seven new investments and upsized as to four existing portfolio companies. We continue to take a disciplined and delivered approach to building a difference portfolio with a differentiated return profile.
We do this by staying at the top of the capital structure limiting our cyclical exposure and focusing on the teams and opportunities where our platform’s scale and sector knowledge provides a competitive advantage. Our new investments this quarter were either asset-based loan solutions or select sponsor financings were expertise allowed us to add value and create appropriate risk adjusted returns for our portfolio.
Moving to the prepayment side, there were $310 million of paydowns across eight full and one partial realizations. These were driven by a combination of opportunistic refinancings and portfolio company specific events. Example of the former is Jive Software. A portfolio company that provides enterprise, workflow collaboration solutions. We made our original investments in Q2 of 2017 to support a sponsor take private of the business. And since then, the company's performance exceeded our underwriting expectations.
During the quarter, Jive refinanced along with a new bank financing at significantly tighter spread. Upon the repayment, we received the call protection and other contractual economics, a result within gross unlevered IRR of approximately 22% of our capital invested. An example of idiosyncratic repayment activity this quarter was Barneys. This April, we funded a $35 million par valued asset-based loan to a luxury department store chain to provide additional liquidity for ongoing operations.
On August 5, the company filed voluntary petition of relief under Chapter 11 of the bankruptcy code. Later that month, upon the funding of a new money debt facility we were fully repaid on our $35 million par value loan, along with call protection of the contractual economics resulting in a gross and levered IRR of approximately 31% on our investment. We continue to be fairly active in the retail ABL this year against the backdrop of a particularly challenging year for brick and mortar retailers.
During the quarter, we funded was 72 million par value asset-based loan to Neiman Marcus to support the company's strategic initiatives. And post quarter-end, as publicly disclosed, we are not affiliated funds provided a 75 million asset-based DIP loan Forever 21 to support the company's bankruptcy restructuring efforts.
We believe both of these investments offer strong risk-adjusted returns given the downside protection of our borrowing-based corporate bonds, including in both cases robust asset coverage from liquid working capital collateral.
Now, let me transition to the portfolio, the composition, and yields. 97% of our portfolio at quarter-end was first lien on a fair value basis consistent with the previous three quarters and our top three industry exposures where business services are 18% of the portfolio at fair value followed by retail and consumer products and financial services each at approximately 14% of the portfolio at fair value.
We would like to note that our retail exposure is predominantly in the form of asset-based loans, secured by liquid working capital collateral, and the vast majority of our financial services portfolio companies are B2B integrated software repayment businesses with limited financial leverage and underlying bank regulatory risk. The credit quality of our portfolio remains robust with an average performance rating on a scale of 1 to 5 with 1 being the highest of 1.13 versus 1.18 in the prior quarter.
This quarter, the weighted average total yield on our debt and income producing securities at amortized cost was 10.8%, a decrease of 54-basis points from the prior quarter. Breaking this down, 24 basis points was due to the decrease in LIBOR on our floating rate portfolio and 30 basis points was due to the impact of new versus exited investments. This was a typical quarter where a number of strong leading investments with the weighted average total yield of 12.7% were repaid.
The weighted average total yield on new investments was lower at 10.4% and this was impacted by both the yield and the size of our Neiman ABL Investment. At a yield and amortized cost of approximately 9% the yield on this loan is on the low end of our typical underwriting range. However, we really like the risk reward this investment offers giving our strong downside protection as discussed earlier. Excluding the Neiman ABL the weighted average total yield on new investments this quarter would have been 11%.
With that, I’d like to turn it over to Ian.
Thank you, Bo. I'll begin with an overview of our balance sheet. Given our net funding activity this quarter, total investments remained relatively flat at 2.05 billion. Total debt outstanding was 918 million, and net assets were 1.11 billion or $16.72 per share, which is prior to the $0.08 per share Q3 supplemental dividend that was declared yesterday. Our average debt-to-equity ratio was 0.86x, compared to 0.85x in the prior quarter and our ending debt-to-equity ratio was 0.83x.
Since we increased our target leverage range to 0.9x to 1.25x, a little over 12 months ago upon the effectiveness of the lower minimum asset coverage requirement, our average quarterly leverage has to date not reached the low end of our targeted range. This is a function of repayment activity in our portfolio, as well as our prudent approach to growth, especially, in today's market.
We’ve instead been focused on expanding the flexibility of our balance sheet to best position the business for the period ahead. As Josh mentioned, post quarter-end we issued $300 million of 3.875% five-year unsecured notes. While the net proceeds were immediately used to repay outstanding amounts under our revolver, the additional capital will also be used to effectively replace the $115 million or 4.5% convertible notes that mature in December, as well as to provide incremental liquidity under our revolver.
We’ve been patient about issuing an index eligible size notes offering given our focus on cost of debt and its impact on ROEs. We executed this transaction to expand our balance sheet liquidity at a swap adjusted pricing that resulted in minimal impact to pro forma ROEs. Further, given our commitment to maintaining our investment grade credit ratings, we believe this transaction provides a meaningful enhancement to the funding diversity profile of our business.
With staggered long-term maturities through late 2024 and over $940 million of availability under our revolver, pro forma for the new notes and the paydown of our maturing 2019 converts we believe we are very well-positioned on the capital side. Pro forma for the repayment of the 2019 unsecured notes in December, our funding mix is comprised of approximately 35% secured and 65% unsecured debt.
Consistent with our risk-management practice of matching our liabilities with the floating rate nature of our assets, we entered into a fixed-to-floating interest rate swap with the same notional amount that resulted in an effective pricing on our new notes of LIBOR plus 225 basis points, which is inside the swap adjusted spread of 286 basis points on the 2019 converts that we will prepay in December.
As we have expressed previously, when we make balance sheet decisions, we are conscious of their impacts on all our stakeholders and believe our actions throughout the course of 2019 have reinforced this approach.
Turning to our presentation materials, Slide 8 is the NAV bridge for the quarter. Walking through the various components, we added $0.55 per share from net investment income against the base dividend of $0.39 per share. There was $0.21 per share reduction to NAV as we reversed net unrealized gains on the balance sheet from investment realizations. Note, that approximately $0.06 of this reversal was related to our equity investments in average exchange in Northern Isle.
As we exited these two positions, we reversed their unrealized gains from the prior quarter and recognized the realized gain on sale in this quarter's net income. Back to our NAV bridge, as Josh mentioned, the impact of credit spread widening on the valuation of our portfolio this quarter was limited and there was a positive $0.02 per share impact from net unrealized mark-to-market gains on the interest rate swaps on our fixed rate securities due to movements in the forward LIBOR curve during the quarter.
Other changes in net realized and unrealized gains, the majority of which were related to the gain on sale of our equity positions had a positive $0.12 per share impact to this quarter's NAV.
Moving to the income statement on Slide 9. Total investment income was $70.1 million, up from $62.4 million in the prior quarter. This was primarily due to the $6.3 million increase in other fees, which consist of prepayment fees and accelerated amortization of upfront fees from unscheduled paydowns. Interest and dividend income was $56.1 million, up $0.6 million from the prior quarter and other income was $2.7 million, up $0.8 million from the prior quarter.
Net expenses increased slightly from $30.3 million to $31.8 million quarter-over-quarter, primarily due to higher incentive fees from an increase in earnings. Interest expense this quarter was slightly lower, compared to Q2, almost entirely due to a lower effective LIBOR on our debt. As you may remember, there’s an approximate one quarter timing lag on the LIBOR reset date on our interest rate swaps.
Therefore, the approximately 20 basis points decline on a weighted average cost of debt outstanding this quarter was related to the decline in LIBOR last quarter. As such, the downward movement in LIBOR during Q3 will be beneficial to our cost of debt through Q4. Josh referenced our [rec related] distribution requirements earlier.
At September 30, our estimated spillover income was approximately $1.60 per share. We will continue to evaluate the best way to comply with this requirement in conjunction with our distribution policy.
Let me conclude with an update on our ROEs. At the beginning of the year, we communicated an annualized ROI target of 11% to 11.5% based on our expectations for net asset level yields, cost of funds, and financial leverage. Year-to-date, we’ve generated an annualized ROI on net investment income and net income of 11.8% and 14.6%, respectively. Given the earnings power of our portfolio and our outlook for portfolio activity for Q4, we would expect to end full-year 2019 at the upper-end of our previously shared NII per share guidance of $1.77 to $1.85.
With that, I’d like to turn it back to Josh for concluding remarks.
Thank you, Ian. In closing, this was another productive quarter where despite ongoing competitive headwinds we were able to underwrite robust risk-adjusted asset level returns and generate strong consistent ROE for our shareholders. We continue to work diligently on finding opportunities where we could differentiate our capital and build our track record of portfolio performance, which today stands at an average growth on leveraged IRR of approximately 19% weighted by capital invested across our 104 fully realized investments. With our portfolio in good shape and with ample liquidity on our balance sheet, we believe we're well-positioned to continue delivering strong returns to our shareholders.
With that, I like to thank you for your continued interest and for your time today. Operator, please open up the line for questions.
Thank you. [Operator Instructions] And our first question comes from Rick Shane from JP Morgan. Your line is now open.
Hi, guys, thanks for taking my question. Look, I know some of the specifics about what you have been saying about Ferrellgas is going to be limited, but love to explore this a little bit. Obviously, at the end of the third quarter, [indiscernible] carried at a gain, an unrealized gain and presumably that factored in things you were anticipating. I’m curious if you can just talk structurally how you guys have looked at some of these situations in the past and help us understand what the opportunity and risks are related to the resolution here?
Great. Hi, Rick, thanks for the question. First of all, at quarter [our franchises support companies and management team even] those that are finding themselves in transition. We’ve tried and we’ll continue to try to work with the company and the management team and their advisers on the solution. We would refer people to the litigation in [Canada] for more details, including the counter suit filed by the company's employees [indiscernible] Great Bank on October 24, for details of the Ferrellgas story.
We believe what’s really unfortunate here is that there’s been approximately $2.3 billion of equity value eroded since the company’s peak market cap in September of 2014, representing approximately $600 million of employee plan assets related to [indiscernible]. This is detailed in the Great Bank counter suit. Obviously, it’s a live situation, which has fluid and as it relates to the mark, the mark is actually below the implied call protection that would be contractual to us upon a refi, if the company choses to refinance.
The company’s capital structure is pretty public. We feel pretty well-positioned in the capital structure, approximately 2.5 times levered. The company does – I think reported $230 million of EBITDA and the market value of the company’s securities, which is mostly unsecured debt. Outside of us is, approximately $2 billion. There is not much equity value by market cap. I think it is like $50 million to $60 million. So, we’re very well positioned in the capital structure.
Obviously, the arc of the Ferrell story again is, you know, unfortunate specifically as it relates to previous, you know, orders and the erosion of the equity value and planned assets. Although we felt pretty good about where we sit in the capital structure, and again, the loan is marked below the implied call protection on our security. Is that helpful?
It is helpful. And obviously given the litigation I know that, you know, you have to be thoughtful about your comments. I appreciate that context. Thank you, Josh.
Just a – there is no current litigation between us and the company. The litigation is really between – at this point is between the [indiscernible] who is the fiduciary for approximately 24% of the company’s stock, which is owned by employees and the company over who controls the company. Again, you can find that in the – in, I think the Federal Court in Kansas, but we’re not a part of any litigation directly with the company today. And again, we continue the work and, you know, to try to find a solution, and, you know, again, you know, our hope of this model is supporting companies and management teams, even those that are in transition.
Great, thank you for that clarification.
Thank you. And our next question comes from Chris York from JMP Securities. Your line is now open.
Good morning, guys, and thanks for taking my questions. So, Rick addressed all technical, so I’m going to focus on the opportunity side for a moment. Josh, you know, when did the middle market software companies was a source of portfolio growth in the third quarter, you know, it seems like it has been over the last couple of years? So, could you be positioned for further growth with the close of the capital solutions fund with more firepower across the platform? And the question I guess for BDC is, in these cases where your lending the software companies by lean tech sponsors or buyouts, are you extending credit as the function of recurring revenue as opposed to free cash flow?
Yes, so good question. I think the portfolio growth this quarter, a decent amount of it I think was actually in our retail ABL team, that’s right. So, and then if you look at our activity in Q4, at least the known activity again is in the retail asset base team with Forever 21. So, we’re most definitely active in business services and software, and quite frankly we’re actually more active in the payment’s ecosystem, for example, than just traditional software.
As it relates to underwriting thesis, it’s a combination of both free cash flow, recurring revenue with high gross margins and the ability for these companies to effectively right size their ability to generate cash flow given that the control sales of marketing will really focus on companies that generate really high returns on a dollar sale marketing spend, and what that really means is that they are very efficient with their capital spend. They generate 3 to 5 times lifetime value of a customer per dollar spent, IR between 25% and 50%, and where they have high gross margins of the 80% to 90%, and low churns for lifetime customers at typically are seven to eight – you know 10 years, but it’s a very granular process.
Each credit is a little different, but it is a combination of what we consider the back book, what’s the value of the recurring revenue and our run off case given that there’s high switching costs, steady state free cash flow profile, and so, it’s a combination of those two. Bo, anything to add there?
No, I think that was well said.
But typically, we are 25% to 40% loan to value, and again, we tend to be very highly selective with high-quality businesses, entrenched customer base, and good return on invested capital.
Yes, the only thing I’d add is, we’re also very sematic in our approach there as well. As Josh mentioned, it’s just not the software companies, we try to pick areas where we think, you know, the return of invested capital will continue because of the secular tailwinds. One area is B2B payments where we spend a lot of time. We’re also looking at the transition from legacy on-prem software providers on some of the vertical applications to more SaaS based solutions like [acousmatic] of this quarter. So, we’re sematic on our approach and how we approach these software names.
Got it, very helpful and investors know that you have been…
Hey…
Go ahead.
Hi, Chris sorry, you asked a compounded question, I forgot the first piece of that question which is, we raised a capital solutions fund focused on basically structured equity and broke that financings and the combination of those two together, that is different than what typically TSLX has done, and – but what it does do is allows – adds foreseen firepower given that there are people in that fund or around that fund who are focused in the same eco-system. And so, there should be accretive opportunities given that we basically increase our sourcing footprint, although it’s a slightly different investment profile, much more down the capital structure than the typical TSLX investment. On occasion, it could be done on capital structure given its some structured equity focus.
Got it. All that insight to a compound question is very helpful. Staying on the topic of themes, maybe Bo, you know investors know you guys have been quite active with your ABL strategy for many years, and then obviously, ex-Barneys seen at a 30% IRR is pretty attractive. You’ve been historically active in retail as a sector for the investment theme, but I’m curious if you think you’re opportunity set could expand to include the extension of the ABLs to older tech business models that could be disrupted by newer tech business either in enterprise software or cloud and leverage your tech expertise across TPG?
Hey, Chris, you did break that when you said we’ve been historically active in – and it broke up, historically active in – what was the premise of the question? We heard the last part, but what was the premise?
The premise was you’ve been historically active in your ABL strategy with retail and curious if you’re expanding that into potentially older tech business models in the extension of the ABL?
Yes, Bo should answer – look, I think the – quite frankly we’re concerned deeply about the old, I would call it, software 2.0 license maintenance models, whether it’s that kind of free cash flow, but really the – in our new license sales, which have being displayed by either on-premise or on-premise solutions or SaaS solutions. And so, we have – you know there is not many legacy software investments in our book. quite frankly, we spent the last 20 years making legacy software investments, our assessments etcetera. But I think that, you know, what we have and what we’re worried about is churn picking up there given the disruption of either on-premise or SaaS. Bo, do you have a different view?
No, that’s – I have the same on that, you know what I’ve mentioned on the previous is, you know, one of our themes is, you know, finding opportunities where we see displacement of legacy on-prem providers. You asked a question about, you know, would we play that on an asset basis? Generally, these companies are software companies that have very little in the way of working capital assets or assets that you could value in a liquid scenario. You know there are some ways to play them, you know, on a legacy harvest mode, but we’re very weary of that play right now, given the rate that you’re seeing deterioration and the retention rate. So, you know, we’re really focused more on Software 3.0, which is the displacement of this in the movement to the cloud, particularly in the, you know, SME market.
Great, again, I appreciate the insight there. And then, maybe for Ian, [indiscernible] questions on the risk management, obviously Josh, you answered this one too. The question is just because the BDC peer had initially saw the match duration of assets and liabilities by swapping their term debt or recently deviated as a result of the cost of swaps in the market, so the question to you is how should we consider your elasticity to the cost of swaps? Or whether the cost of swaps did make you reconsider your risk management strategy on an ad hoc basis?
Yes, so I think what you’re referring to us given that the LIBOR curve was embedded that the swap cost was higher than the fixed cost at time plus – at T plus, zero T plus 1. Chris, is that what you’re referring to?
Correct. Yes.
Yes, and that being said, right, the swap cost is effectively the net present value of the curve at that point. And so, what – the implicit bet that that manager is making is a bet on the curve that the curve will wrong and it won’t be inverted or inverted as much. Again, we have no ability to determine interest rates. You know we own floating rate assets. We have floating rate liabilities. In the case where you have an inverted LIBOR curve, what it’s telling you is that your assets – if your floating rate assets, they are going to be showing off less income in the future, right.
So, T plus a year or T plus two years, and if you didn’t swap, you’ll effectively have net interest margin impression at T plus one or T plus two, right. And so, that again we try to stay away from the implicit bets you made – that people are making on the curve or on the shape of the curve and effectively trying to lock in a net interest margin on our portfolio. And so, that’s how we think about it, but what – if the curve stayed exactly the same, and they own a floating rate portfolio, a year from now or two years from now what’s going to happen is, their interest and income from that portfolio is going to go down and their interest expense is going to stay exactly the same and they’re going to have net interest margin impression, which is the thing we’re trying to avoid. Anything other?
No, I think the approach we took this time, Chris, is just staying true to the philosophy that we’ve put in place before, so no deviation from that same approach.
Yes, I would say when did the swap, that wasn’t the case for us, right. It was basically flat to the cost of the bond deal, but we’re not – again, we’re not making bet from the shape of the curve. We’re really focused on just, you know, locking in a net interest margin.
Got it. Thanks for the clarity on that and just contrasting the differences in approach there I think is important, so that’s it for me. Congrats on the productive quarter.
Thank you. And our next question comes Mickey Schleien from Ladenburg. Your line is now open.
Yes, good morning everyone. Josh, I think in your prepared remarks you talked about bifurcation in the markets, and, you know, I do agree with that, we’re seeing bifurcation, leverage loans with, you know, some more weakness in retail and energy and in some other deals, which may have been too acquisitive or maybe too optimistic on their synergies. Taking that into account and your platform's broad expertise in general and in some of these segments specifically, you know, how would you characterize the risk adjusted returns available to you in some of those, you know, more liquid, but distressed names versus more day-to-day deals?
Yes. So, hey, Mickey, so first of all, you’re exactly right. I think the loan – the broadly syndicated loan market is getting a much larger tail, i.e. the percent trading below 95% or 90% is much higher than it, you know, has been historically. Our view is that there is – there are good reasons why those loans are trading where those loans are trading. And I don’t think we’ve found value in those loans today. We obviously have a broadly syndicated loan book outside of the BDC and we’re very much in tune with what’s happening in the broadly syndicated loan market.
I would say generally that it’s not a technical dislocation, it is really – the tail is being caused by fundamental issues either in those business models or with those names in an idiosyncratic basis. So, if its parts of the healthcare ecosystem, if its parts of energy or retail there are non-asset-based lending opportunities. There’s most definitely a reason why that exists, so I don’t think we’ve – you know it doesn’t feel like a, you know, December/January 2018, 2019 or a [December 15, March of 16] where there is broad based dislocation, it felt like the dislocation exist for reason and it doesn’t seem like there’s a lot of excess return in those tails at the moment.
That's interesting, Josh. And sort of a spillover of all of that is into the CLO market, which, you know, effectively looks like it’s shut down at least in the primary market, and that looks like it may be presenting some interesting opportunities in CLO equity to the extent there’s any [liquidity]. Is that a bucket that’s more interesting to you today than perhaps a few months ago?
Yes, maybe we’ve had a – as you know, Mickey these are really good impactful broad market questions. I got to give it to you. You’re in tune, you’ve done your work. The – which is obviously, you know, historically been the case with you, but – so as you know, CLO equity – we have not purchased any CLO equity in the BDC for a lot of reasons, most definitely due to the ball now of [indiscernible]. Where we have stepped in a little bit is in the mezzanine. I think back in 2016, we bought two mezzanine bonds and those were pre-valued and we exited it.
So, I can imagine that we’re – that we’ll come to a conclusion that the CLO equity opportunity is right for BDC. There might be a small basket on the structure credit size on mezzanine bonds or other bonds. I would tell you that unlike 2015, 2016 where the dislocation was felt technical and it was broad based and – which created the opportunity, CLO equity today, I think, is really again is focusing on those tails, but deeper down in the capital structure we review our – in the structured credit land.
So, mezzanine and equity, you’re way more levered to those tails given the implicit leverage in the CLO structure. And so, if you’re negative on the loans that have – negatively broadly in the loans that have tail, you got to be – you would have to be very careful as it relates to the levered piece of a CLO structure that is most exposed to that tail. Now, there’s offsetting factors such as, you know, the ability to invest, the ability to trade, that might offset some of that tail risk.
That being said, the other thing that’s happening in the CLO market is the risk downgrade and the breech of OC test that will take some of the optionality. And so, you know, the big, you know, elephant in the room in the CLO market is there’s two, which is the tails in the portfolio and the second piece is, you know, how much downgrade risk from B3s, B minus is to triple Cs that really will truncate the optimality for the equity.
I understand and that's really helpful, Josh. I appreciate your time. Those are all my questions today.
Great, thanks Mickey.
Thank you. [Operator Instructions] And our next question comes from Robert Dodd from Raymond James. Your line is now open.
Hi, everyone. On the – I appreciate the color at the beginning of the call from Bo with, you know the prepays that came this quarter obviously generated some fee income and as a result the IRRs, which also, you know, you reversed out in unrealized depreciation because you’d put it in. Can you give us any color on at what point of certainly or probability of an early prepay do you start to factor that call protection into the unrealized – or that the fair value mark on the books?
Yes, so look, the way we value our book is, we really look at change of credit spreads since inception. And so, if credit spreads on that – on the comp credits or in that interest we have tied in, the loan will go up typically tapped by either time value i.e. that you don’t – in loans you don’t hold a – you write off a – the issuer call option, so you can’t hold an over market loan forever because they can call you at a price. And so, it’s typically capped at the time value or the call price, the combination of the two. If loan spreads widen, you obviously are marking down the loan based on your underlying duration assumption of that loan. And so – and then you make idiosyncratic adjustments as it relates to the company performance, where would it reprice today and what we’re really trying to do is figure out what the fair value of that loan is and where would an arms-length party transact.
As it relates to how we’d start factoring coal prices that’s part of the idiosyncratic adjustments, which is we think the company is going to be sold, what’s the probability of the company who’s going to be sold, you know, so what’s the probability of us – we’ve seen that call price and what’s let the expected value, and then, you incorporate that into the loan. Sometimes it’s a 100, sometimes it’s 25, and then you make adjustments quarter-by-quarter as it rolls through. And so that is how the valuation works, but again, the overall arching kind of contact is where would a third-party at an arm’s length buy that loan, or where would it – where would be priced in the environment we’re all living today and there is a whole bunch of tools you use, the biggest tool is changing credit spreads since inception and then you overlay with the idiosyncratic.
Got it. I appreciate that color. And then, just one more if I can, on the Neiman ABL in the quarter, as you said, I mean the yield 9%, but you didn’t maybe underwrite and ABL to a yield, that’s of course a yield to worst, so I mean what you – as we saw with Barneys that’s 31% IRR, right, and so what would you say where would the Neiman ABL stack in terms of possibly expected to return versus your portfolio yield today?
Yes. look, so first of all I think one the ways we would get it is, you know, yield kind of what we would expect it as an expected life, not yield to worse and that’s a function of things that are happening with the company, risks – some of the – our ABL investments, you know quite frankly when the companies are facing challenges those investments tend to yield better than the yield to worse because they have a shorter life. And so, you are correct. We didn’t underwrite it to a 9% yield. We expect that the average life will be shorter. That being said, you got to look at the quality of the – your collateral and the quality of your business, of a business.
What we mean is, as a good business obviously has balance sheet issues and we quite frankly had a ton of experience with the underlying collateral most recently with Barneys for example and felt great about that there is very, very little probability of loss given that we have a borrowing base yield as well in side of the loan to value of – on the liquid collateral, the inventory. The other thing that worked nicely about Neiman is that there is a whole bunch of suppressed availability i.e. that the basket for the silo was much smaller than the – if there was limit basket to the silo I think of $100 million which was much smaller than a typical advance rates with support given the collateral base.
Okay, I appreciate. Carry on.
It is a much less full, kind of silo or active based loan in a typical – asset-based loan given the baskets that the company had available to those.
Got it. I appreciate it.
Thank you. And our next question comes from Finian O'Shea from Wells Fargo. Your line is now open.
Hi, guys. Good morning. Thanks for having me on. Just to continue on Neiman’s touch. This is one, just looking at as a well-known, of course this is a large ABL loan and of course many private credit competitors are building out in this space, so can you talk a little on the competition here, what was this shopped around or are you – were you brought in with or behind a bank? And then just a small add-on to the question there is a seemingly very small piece of the syndicated first lien that you took on, is this a new, did you buy that secondary or did this come with sort of your investment as a second part to that question?
Yes. So, good question Fin, and good morning to you. So, on Neiman look, we have a great relationship with our friends at [indiscernible] have done numerous asset based deals including $0.99 and so we have a great relationship and in addition to that we were involved on one of our other funds, our private funds and helping Neiman through the latest restructuring given we are a large holder of the term-loan. So, given that we’ve, now the company has been involved with the company or a construct of with the company and then latest efforts to restructure the balance sheet, we have a ton of experience with the sponsor and I think that gave us the opportunity and so that’s the context of the transaction.
Again, what I would say is, look the portfolio yields bounce around quarter-to-quarter. I think if you look at Forever 21 quite frankly, which is another retail asset-based loan as a much higher yield in amortize cost. If much, much higher, if you look at portfolio, if you proforma Q3 for Forever 21, I think yield and amortized cost of our portfolio is about 11% to 11.1%. and so, that – the Neiman’s choice was, those were a yield, it probably ultimately will have a little bit of higher return because we will go to like, there is a whole bunch of suppressed availability, which have made a very good loan.
We knew the company and we have a great relationship with the sponsor and have a history supporting Neiman. As it relates to your second question, which is, why do we own a, I think it’s like [indiscernible] of Neiman first lien, it is under the 40 Act given that we own a different part of that capital structure [indiscernible] first lien and Neiman helped solve some of the restructuring exemption if ever Neiman is in active workout. And so, it was a small investment to deal with some of the 40 Act considerations and give us regulatory of flexibility under the 40 Act.
Interesting. A follow-on if I may, I think in your dialogue with Mickey, and if you outlined a view that a lot of the secondary B2, B3 loans are down where they are in the 70s for example for a reason, can you – where are you in the camp of, you know today with a little chop in the market, a lot more sponsors looking at a private solution for more complicated deals or even less complicated deals. Where are on the spectrum of, is there much better opportunity now in a traditional sponsor large cap deal?
I think the generally volatility and probably syndicated markets leads to opportunity for the private credit market. So, I think that’s generally the theme. What I would say is, what I would caution is, first that volatility needs to be, it can’t be one day, two days a week, a month, it is got to be probably 60 days to 90 days where people are willing to pay for certainty. The second thing is, given there has been a lot of private credit raise, you know our view is, that if you are going to take on liquidity risk you got to earn a little bit of an excess premium and I’m not sure everybody shares that view.
That being said, I think generally we are starting to see some larger transactions, I think if you looked at a $900 million deal that was going to be clubbed up to private credit guys in the last couple of weeks. And so, I think you’re starting to see some of that, but again, I think, I would caution people that given where BDC’s sit on and fee structures that they got to remember that they are not a CLO where they charge 50 basis points, so they better be creating value to earn their fees. And that it takes a little bit of, it takes a little bit longer to same periods of volatility, but I hope that answers your questions.
Yes, it does. Thank you for taking my questions.
Thank you. And that concludes our question and answer session for today. I’d like to turn the conference back over to Joshua Easterly for closing remarks.
Great. Well, thank you very much. I appreciate people spending time with us this morning. I hope you people have a wonderful Thanks Giving and a holiday season, a winter holiday season and then we will talk to you in Q1, if not before and feel free to reach out to the team Ian, Lucy, Bo and myself for any specific questions. Great. Thanks all.
Ladies and gentlemen, this concludes today’s conference call. Thank you for participating and you may now disconnect.