Sixth Street Specialty Lending Inc
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Sixth Street Specialty Lending Inc
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Good morning, and welcome to Sixth Street Specialty Lending Incorporated September 30, 2020 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 the 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 result of a number of factors, including those described from time-to-time in Sixth Street Specialty Lending, Inc.'s filings with the Securities and Exchange Commission. The company assumes no obligation to update any such forward-looking statements.
Yesterday after the market closed, the company issued its earnings press release for the third quarter ended September 30, 2020, and posted a presentation to the Investor Resources section of its website www.sixthstreetspecialtylending.com. The presentation should be reviewed in conjunction with the company's Form 10-Q filed yesterday with the SEC. Sixth Street Specialty Lending, 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, 2020. 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. Good morning everyone and thank you for joining us. We recognized that an ongoing pandemic continues to present very real and unique challenges for everyone and their families. So we're grateful to those who were able to join us today and thank all our stakeholders wherever they are for their continued interest and partnership. Once again, I'm here today with my partner and our President, Bo Stanley; and our CFO, Ian Simmonds, both of whom you'll hear from later on this call.
After the market closed yesterday, we reported strong third quarter results with net investment income per share of $0.61 of overearning our Q3 based dividend per share of $0.20. Net income per share for the quarter was $1.21. These results correspond to an annualized return on equity on net investment income of 15.1% on net income of 30.1%. On a year-to-date basis, we've generated an annualized return on equity on net investment income of 13.5% and net income of 14.7% based on the beginning year pro forma net asset value per share of $16.77, which is adjusted for the impact of our Q4 2019 supplemental dividend of $0.06 per share.
Of note, these annualized year-to-date return on ROEs both exceed our average annualized performance since our IPO through the end of 2019, which we think is notable given the difficult operating conditions experienced during the first three quarters of 2020. That said based on market conditions today, we believe there are tail risks that all BDC portfolios are subject to including credit risk and earning headwinds from LIBOR, which in our portfolio is offset by our LIBOR floors in the floating rate nature of our liabilities. Our strong net investment income this quarter was a function of both robust interest and fee income as well as lower interest expense attributed to the 100% floating rate nature of our liability structure, which Ian will cover in more detail.
This quarter's net income was supported by unrealized gains related to portfolio company-specific events, spread-related unrealized gains from the continued tightening of credit risk premiums during Q3, and realized gains from the sale of our AFS equity position at a price that was significantly above our prior quarter's unrealized mark, which Bo will cover later on the call. This quarter's operating results contributed to the growth and our net asset value per share, which had our record high of $16.87 at the end of Q3. This represents approximately 5% increase from Q2 and 1% increase from our 2019 year-end pro forma NAV per share of $16.77.
If we were to add back the impact of the $0.50 per of special dividends that were paid during Q2, we've grown net asset value per share by approximately 4% year-to-date. To reflect on this for a moment in a year we've experienced tremendous market volatility and economic uncertainty, we've actually been able to grow net asset value per share while paying our highest level of dividends for the first three quarters of the year. This reinforces our belief that we've created a differentiated business model that not only survive, but has the ability to outperform during periods of uncertainty.
Notable drivers of net asset value growth year-to-date includes $0.47 of overearning against our base dividend $0.23 of unrealized gains from the impact of effective LIBOR floors of 1.1% across our portfolio versus 36 basis points for the broadly syndicated loan market, $0.12 of net mark-to-market gains on our interest rate swaps primarily related to our 2022 and 2023 notes and $0.11 of net realized gains on investments. And in the short periods of volatility across Q2 and across rate, we deployed approximately $150 million of capital across a combination of secondary investments and opportunistic financings.
Through quarter-end, these investments have generated $24.4 million of P&L of which $9.7 million has been recognized in investment income. Therefore, post fees were generated today $22.7 million of value or $0.34 per share solely through investments we made during the period of volatility earlier this year. Based on a net asset value rebound and the overearning of our base dividend this quarter, our board declared a supplemental dividend and dividend in accordance with our formulaic dividend approach, a supplemental dividend of $0.10 per share, which is half of the quarter's overearning was declared yesterday to shareholders of record as of November 30 payable on December 31.
Our board has also declared a fourth quarter based dividend per share of $0.41 to shareholders of record as of December 15 payable on January 15. Adjusted for the impact of the supplemental dividend related to this quarter's earnings, Q3 pro forma net asset value per share was $16.77. Now let me shift over to a brief update on our portfolio. The latest performance data continues to support our confidence in the overall health of our bars. While none of our portfolio companies have been immune to the economic impact of COVID, only 11% of our portfolio by fair value at quarter end has experienced meaningful performance issues directly related to it.
We believe the relative resilience of our portfolio is mostly a result of a deliberate shift we made in late 2014 towards a more defensive portfolio construction. Today, 95% of our portfolio by fair value is first lien and nearly 75% of our portfolio by fair value is comprised of mission critical software businesses with sticky predictable revenue characteristics. These businesses also tend to have variable cost structures that it can be fluxed down to support debt service and protect liquidity in cases of challenging operating environments.
The general nature of our portfolio along with this first lien orientation, shorter way to average life and above market LIBOR floors contribute to a lower beta characteristics to the benefit of our shareholders in times of market volatility. At quarter end, our debt portfolio had a weighted average fair value mark of $99, up 3 percentage points from its recent trough at the end of Q1, but below our pre-COVID levels of approximately par at the beginning of the year. Meanwhile, the Leveraged Loan Index at quarter end had a weighted average bid price of approximately $95, up 11 percentage points from the end of March and also below its pre-COVID levels of approximately $97 at the end of the year.
As we've previously pointed out, the lower beta of our portfolio is due to a shorter weighted average life and higher LIBOR floors compared to the leverage loan market. Note that the weighted average bid price for LCD first lien software names like our portfolio also experienced less volatility than the broader loan index during this period. While portfolio has held up relatively well over the past couple of quarters, we'd like to reiterate that credit tail risk do exists in our portfolio and more so today than pre-COVID. At quarter-end 12% of our portfolio had a fair value mark of less than $98 compared to only 8% of the portfolio in Q4 2019.
The weighted average fair value mark for names in this tail at the quarter end was $88 compared to $96 at Q4 2019. Revisiting the concept of anti-fragility, the headwinds in our portfolio from credit year-to-date have been more than offset by the tailwinds and the value we've been able to create during the periods of market volatility across Q2 and Q3. There was a slight increase in our non-accruals this quarter from 40 basis points and 90 basis points on a fair value basis. This was primarily driven to the addition of first lien loan in MD America, an upstream E&P company, which is partially offset by removal of our pre-petition Neiman Marcus term loan and a partial roll up of our JCP's pre-petition first lien term loan into the debt term loan.
On MD America, we received a roughly scheduled cash – our regularly scheduled cash interest payment during the quarter, but applied those proceeds to the amortized cost of our position given our view of an imminent reorg of the company's capital structure that result in a reduction of the value of our loan. Post quarter end, the company made a voluntary pay down of $1.4 million on our position and are subsequently filed for protection under Chapter 11 that implements prepackaged plan of reorganization. For Q4, we expect to put $9 million of our loan or approximately 70% of our remaining pre-petition loan at 9/30 fair value, back on accrual status upon the company's emergence from Chapter 11. Our remaining investment will be restructured into an equity position. Note that the quarter-end, our total energy exposure was 2.4% of the portfolio at fair value.
With that, I'd like to turn the call over to Bo to walk you through our portfolio activity and metrics in more detail.
Thanks, Josh. During the third quarter, conditions continued to stabilize in the leverage loan market as unprecedented levels of fiscal and monetary stimulus supported ongoing investor demand for risk assets. Secondary loan prices continue to recover in Q3 and primary issuance activity slowly reemerged in connection with opportunistic financing M&A. On an absolute basis, however, leveraged loan activity in Q3 remain muted compared to historical levels resulting 10 year low for year-to-date new issuance volumes.
These trends carried across the middle markets where our overall activity remained modest. However, we noticed a notable increase in sponsor activity later in the quarter and into Q4. In contrast to the muted issuance activity in the loan markets, we had record Q3 originations activity with our highest level of commitments since inception at $436 million and our second highest level of fundings at $332 million. This activity was across 12 new and 4 existing portfolio companies. As alluded to on our last earnings call, despite the lack of middle-market sponsor M&A since March, we had a very strong pipeline headed into Q3, given our diverse sourcing channels and deep sector relationships as part of our thematic investment approach.
At a high level, this quarter's new investments were probably predominantly non-sponsored transactions for our underwriting and sector capabilities along with significant dry powder across the Sixth Street platform allowed us to be value add partners for companies and their management teams. Examples of this include the $500 million term loan facility that we underwrote with our affiliated funds for the publicly traded biopharmaceutical company, Biohaven, similar to our prior investments in Nektar and Ironwood. Our Biohaven facility is secured by all assets of the company, including royalty streams from an FDA approved drug and therefore faces no underlying regulatory approval risk.
In addition, certain delayed drop portions of our commitments are only available subject to the company meeting key revenue milestones. We've had a historical success with our investments in the underlying theme and believe Biohaven continues to exemplify the strength and the expertise of Sixth Street's healthcare franchise. Other new investments we originated this quarter include $175 million ABL term loan for Designer Brands of which we hold $50 million and $125 million accounts receivable securitization facility for Centric Brands, both of which continue to exemplify our differentiated capabilities as solution providers in the consumer and retail sector.
Post quarter end, we fully exited our investment in Centric Brands in connection with a new financing obtained by the company as it emerged from bankruptcy. As Josh alluded to in his opening remarks, during our three month hold period, we generated a P&L of $3.8 million on our investment represented a gross unlevered IRR of 31% on our capital invested. Other ways we created value during the short burst of volatility across Q2 and Q3 or through small opportunistic secondary market purchases and sectors or names that we know well. For example, we purchased $50 million par value of Tech Data syndicated by low term loan at $92 in July and completed the sale of our entire position post-quarter around at a weighted average price of $98.4. Vertafore's first lien term loan was another liquid security that we purchased in late March at a price of $78.25, and sold during Q3 at a price of $99.8.
Finally, the combination of our small BBB and BB rated CLO purchases throughout Q2 and Q3 have to date resulted in nearly $0.5 million of P&L for our portfolio. So not one of our primary investment themes, these opportunistic secondary market purchases continue to be an efficient way for us to enhance the return profile of portfolio when the market environment permits. Q3 was also active for us on the repayment side with $253 million of repayments across eight full and five partial realizations, and the combination of a funding and repayment activity during the quarter resulted in net fundings of $79 million.
The bulk of this quarter's repayments were driven by three investments, our $72 million Neiman ABL FILO upon the company's reemergence from bankruptcy. Our $51 million Dye & Durham first lien loan in connection with the company's IPO and our $45 million AFS first lien loan and equity positions in connection with a sale of a company to a strategic buyer. Some of you may recognize AFS as one of our longest standing portfolio of companies, with our first investment dating back to 2011.
Since the original investment, we supported the company through various transitions and ownership changes, including the sale of our majority equity ownership stake to the sponsor in 2018. We believe AFS, an example of our asset management capabilities along with our flexible capital base allow us to be long-term value added partner for management teams and sponsors. For our shareholders our equity position in AFS was fully realized as quarter at a value of $16.2 million compared to our prior quarter's fair value mark of $7.3 million.
Moving now to portfolio yields. The weighted average total yield on our debt and income producing securities at amortized cost increased by approximately 20 basis points to 10.2% this quarter, primarily driven by the favorable impact of this quarter's funding activity. The yield at amortized cost of new investments in Q3 was 11.5% compared to 10.8% for exited investments. Note that LIBOR move into Q3 had minimal impact on this quarter's portfolio yield given that LIBO had already fallen below the effective average LIBO floor across our portfolio in the prior quarter.
Now a brief update on our portfolio composition and credit stats. Our top two industry exposures continue to be stable led by business services at 22.9% of portfolio at fair value followed by financial services at 16%. Retail and consumer products was our third highest industrial exposure increasing from 11.3% to 13.9% quarter-over-quarter; this was primarily driven by new fundings for designer brands and centric brands, which was partially offset by the repayment of the Neiman ABL FILO Term Loan. Pro forma the pay down of Centric Brands, our retail and consumer exposure would have been 10.5% at quarter-end and retail names – with retail names comprising 9.5% of the portfolio and 77% of this exposure consisting of ABL investments.
In September, upon the full repayment of the Neiman ABL FILO and debt loans, we subsequently funded a new $17 million par value first lien loan related to our exit financing backstop commitment. And our schedule of investments roughly $4 million difference between the par value and the cost basis of the new Neiman loan reflects our fees on the backstop, which were payable and common stock of the reorg company. Our loan today is trading at a price of approximately 104.75. This again was another way that we created value during the volatile market environment earlier this year. We believe our attractive cost base along with the company's high quality assets and improved perspective cash flow profile post restructuring provide considerable downside protection on our investments.
As Josh discussed earlier, the overall performance of our portfolio continues to remain relatively resilient, which is a testament to our team's deep knowledge of the industries, where we are active and our close relationships with our portfolio company and management teams. A portfolio weighted average performance rating was 1.21 compared to 1.23 in Q2, on a scale of one to five with one being the strongest. There were no material changes in the overall credit metrics of our portfolio companies.
Interest covers this quarter remain flat at 3.3X, net attachment point was unchanged at 0.4X, and that leverage increased slightly from 4.3X to 4.4X, which is on par with our trailing two-year historical quarterly average. The weighted average annual revenue and EBITDA of our core portfolio companies increased slightly this quarter to $117 million and $36 million given our migration towards larger borrowers, as well as organic growth of certain existing borrowers. While the path of this economic recovery remains highly uncertain; based on our close engagement with our borrowers we don't expect any material deteriorations in the overall performance of our portfolio in the near-term.
With that, I'd like to turn it over to Ian.
Thank you, Bo.
I'll begin with an overview of our balance sheet. Total investments at fair value increased by $118 million quarter-over-quarter to $2.1 billion, primarily driven by this quarter's net funding activity and the net unrealized gains on our investments. Total principle amount of debt outstanding was $932 million, and net assets were $1.14 billion or $16.87 per share. Our debt-to-equity ratio at quarter-end was stable at 0.81 times due to the combination of the delivering impact from this codes increase in net asset value offset by net portfolio funding.
Our average debt to equity ratio increased from 0.87 times to 0.93 times quarter-over-quarter, due to the timing of our Q3 repayments, which were mostly weighted towards quarter end. On capital and liquidity, we continue to be strongly positioned, ready to capitalize on potential market dislocation. As Josh discussed, our capital and liquidity position has aided our ability to capture value for our stakeholders during these volatile times. Our financial leverage of 0.81 times remained well below the regulatory limit of two times. And we had ample liquidity at quarter end with $1.02 billion of undrawn revolver commitments.
For context, our current liquidity represents nearly 50% of our total assets. And we had 12.4 times coverage on our $83 million of unfunded commitments available to be drawn by our borrower based on contractual requirements in the underlying loan agreements. This compares to peer median using June 30 data of approximately 21% liquidity as a percent of total assets and only 4.4 times coverage on unfunded commitments. At quarter end, our funding mix was comprised of 69% unsecured and 31% secured debt. And our nearest maturity was approximately two years away and only $143 million principal amount. We continue to be matched funded with a weighted average remaining life of our investments funded with debt of two years, compared to a weighted average remaining maturity of four years on our liabilities from revolver commitments.
Turning to our presentation materials. Slide 8 is the NAV Bridge for the quarter. As Josh mentioned, the overearning of our base dividend continued to be an important driver of our NAV growth, contributing a positive $0.20 per share to this quarter's results. There was $0.07 per share reduction to NAV as we reversed net unrealized gains on investment realizations and recognized these gains into this quarter's net investment income where applicable. We also benefited from a positive $0.22 per share impact from unrealized gains related to credit spread movements on the valuation of our portfolio. And other changes added a further $0.46 per share to this quarter's NAV. Making this loss component down, the leading contributors were $0.17 per share of realized gains on our AFS equity position, $0.08 per share of unrealized gains on our Vertellus equity position, and $0.07 per share of unrealized gains on our new Neiman Marcus.
Moving to the income statement on Slide 10. Total investment income increased to $71.3 million compared to $70.2 million in the prior quarter, this was primarily driven by an increase of $4.4 million in interest and dividend income due to an increase in the average size of our portfolio. Other fees, which consists of prepayment fees and accelerated amortization of upfront fees from unscheduled pay downs continued to be relatively strong at $9.3 million led by our fees related to Dye & Durham and now Neiman ABL FILO.
Other income increased from $6.5 million to $8.1 million quarter-over-quarter, primarily due to the receipt of a one-time termination fee for a commitment we made in Q1 of 2019, but it was never eligible to be funded given the required milestones in the underlying loan agreement we're not satisfied. Net expenses this decreased by $1.6 million to $28.2 million, primarily driven by lower interest expense from a lower effective LIBOR on our entirely floating rate liability structure; this quota, our weighted average cost of debt decreased by a notable 90 basis points. This was primarily a function of movement in LIBOR during Q2, which flowed through our cost of debt in Q3 due to the one-quarter timing lag on the libel reset dates on our interest rates swaps.
As a reminder, given our view that our competitive advantage resides in underwriting and managing credit risk, not interest rate risk. We have a longstanding practice of matching our liabilities with the predominantly floating rate nature of our assets, which are protected on the downside through our LIBOR floors. We do this by implementing fixed-to-floating interest rate swaps on our fixed rate debt.
While our hedging policy means that we forgo some earnings upside in higher interest rates environment, it provides us with valuable earnings and capital support in lower interest rate environments, which is when we may needed the most given their correlation with recessionary periods. In falling rate environments like we've experienced you today. We benefit from net interest margin expansion, given a decrease in the cost of that floating rate liabilities, while the earnings power of our contractual floating rate assets is protected by the LIBOR floors that we've structured into our loan agreements.
The combination of these two forces has been the primary driver of the 100 basis points of net interest margin expansion we've experienced year-to-date; equating to incremental earnings of approximately $2.4 million or $0.04 per share. Looking ahead into Q4 based on our current asset level yields and assuming average leverage in line with Q3, we would expect further net interest margin expansion of approximately 10 basis points based on this quarter's movement in LIBOR.
On the capital side year-to-date we've benefited from unrealized mark-to-market gains on our interest rate swaps, given the downward movements in the shape of the forward LIBOR curve. At quarter-end we had $31.3 million of cumulative unrealized gains with $13.3 million or $0.20 per share embedded in our $9.30 NAV. The remainder is reflected in the carrying value of our 2024 Notes due to our application of hedge accounting on those swaps. As we've seen, the inverse relationship between movements in the forward curve and the mark-to-market on our swaps creates valuable, incremental capital cushion for our business in periods of high volatility.
We'd like to note that as we approach the maturity of our 2022 and 2023 Notes, and therefore the maturity of our respective flop instruments, any cumulative swap related unrealized gains or losses will unwind from NAV as we recognize their offsetting impact through interest expense. For example, holding the forward LIBOR curve constant as of $9.30, we would expect to see an unwind of $0.09 per year to our NAV per share over the remaining weighted average duration of 2.1 years on our 2022 and 2023 Notes. As we simultaneously benefit from lower interest expense and our net investment income.
With that, let me wrap-up with the word on our full-year guidance. Year-to-date, we've generated an ROE on net investment income of 13.5% based on year-end 2019 pro forma NAV per share of $16 77. This puts us ahead of that NII guidance, which was based on an ROE target of 11% to 12%. Given the performance of that portfolio today, and our visibility into the strength of our investment pipeline, we are revising our full year 2020 NII per share guidance to be in excess of $2.11.
With that I'd like to turn it back to Josh for concluding remarks.
Thank you, Ian.
It goes without saying, and nobody could have predicted the operating environment we face for the first three quarters of 2020. But we're proud of what our business and people have been able to accomplish. In the midst of a pandemic with the majority of our team continuing to work remotely we've generated record originations activity and attracted one of the strongest full year ROE for our shareholders in our view.
Now this would have been possible without understanding of the unique constraints and challenges of the BDC model and the measures we've implemented on both sides of our balance sheet to help our business drive in periods of uncertainty. That said, we continue to evolve our thinking based on our assessment of underlying risks, trends and developments in the world around us. This includes an ongoing assessment of our liquidity and funding profile, as well as an evolution of investment themes into new sectors of strategies. We believe our human capital can be applied to generate value for both of our shareholders and our clients.
As a business, it's hard not to be reflective given that we founded Sixth Street during the financial crisis 11 years ago, and today we're faced with an ongoing pandemic. In our view, these two regressive events have shed light on the fact that we still haven't confronted the history and legacy of institutional racism. And we've continued to live with the consequences of our failure to deal with massive loss in the quality. We firmly believe that the adversity and upheaval in our society today can create tremendous opportunities for improvement, not just lead to dark places.
Looking ahead, our hope is that we all and whatever ways we can focus on healing conversations, equity and in a roles as market actors insists that we preserve the power of capitalism, which we firmly believe creates the best outcomes for society, albeit in a better modified way. We will leave you with one of our favorite thoughts from the reverend Dr. Martin Luther King, Jr., the arc of the moral universe is long, but it bends toward justice.
With that, I'd like to thank you for your continued interest in your time today. Operator, please open up the line for questions.
Thank you. [Operator Instructions] And our first question is from Rick Shane with JPMorgan.
Good morning guys and thanks for taking my questions. I wanted to start by just looking at the pending maturities within the portfolio. When we look at 2020, you have one sort of normal way transaction that's maturing, which is Quantros, it's carried a little bit below fair value, or excuse me, a little bit below cost. I'm curious what the path there is? And then as we look into 2021, you've got three significant maturities, MedeAnalytics, IRGSE and then 99 Cent Stores. Those are all carried slightly above costs. I suspect 99 Cent is doing very well. If you could just give us a little insight on the other three investments, that would be helpful.
Sure. Hi, Rick. Good morning. So Quantros is actually in the sales process. Bo correct me if I'm wrong, it sold about – we had a significant pay down, has sold some assets, software and analytics business sold some assets maybe a year and a half ago, two years ago. They're in the process of selling the rest of the business. So I expect that to be cleared up. IRG is a controlled portfolio company. 99 Cents is doing well and there's going to be a significant refi risk. And what was the other one there?
The other one was MedeAnalytics and that has paid off, that that business was sold and has since paid off.
Great. Okay. And then that's very helpful because obviously everybody is sort of asking about maturity default, so that clears that. The other…
Hey, Rick, just let me – I want to clarify, because I think you're talking, you're focused on like this tail concept of tail risk in existing portfolios. And I want to clarify one of the things we talked about in our earnings call because the information, the names that we shared earlier included new names in each of the respective periods that the mark for less than $98, which could have had an impact from OID.
So if we booked the new name, it's going to be at OID. If the mark is going to be less OID, it was included in tail names even though that it probably – it's not really a tail name. If you exclude the new names that are obviously not tail risk names at quarter end, 8% of our portfolio had a fair market value of less than $98 compared to 4% at Q4 of 2019. The average price of those tail names in Q4 was $95 compared to $85 in this quarter.
Got it. Okay, that's helpful. You you're right. I was thinking a little bit about tail risk. The other investment I'd like to just talk about is Biohaven, which I think is sort of a different investment for you. If we look that's a company that is consistently losing money, seems to be burning cash. I realize your portion that facility is relatively small, but just like to talk a little bit about what's driving, what appears to be a different type of investment in that particular company.
It's actually not. It's the same exact investment that we had in Ironwood and Nektar. So those were large biotech companies, who had an in place IP and drugs that had sales, and then they were investing in R&D to expand the portfolio. And so if you look at the exist – if you kind of parse out the business instead their existing drug portfolio that has revenue, that has in place IP, and you looked at that, and you looked at the DCF of the value of that in place IP it significantly covers our loan. And so, it's exactly the same theme as Ironwood and Nektar, who both paid off and were good investments for us.
So there's kind of a couple of different types of biotech businesses, one biotech business, one set of biotech businesses that have no in place revenues, no cash flows all kind of on the com, those don't have a credit story. Then there are biotech companies who have drugs or portfolio of drugs, but they're massively reinvesting in new drugs. When you parse out, there is an underlying credit story either based on royalties or the value of IP from in place drugs that are providing revenue. And so Biohaven actually has the market leading migraine drug, one of the market leading migraine drugs.
Got it. I think in the current environment exposure to migraine relief is probably a good place to be. Thanks for the color guys.
Yes.
Thanks guys.
I mean – but I think Ironwood was like IBS-C constipation medication or so – or – yes, I think the Ironwood. So that could have been applicable too.
Fair enough.
Thank you. Our next question comes from Devin Ryan with JMP Securities.
Hi, good morning, everyone. Thanks for taking my questions.
Hi, Devin. Welcome.
Thank you. I appreciate it. And maybe start here with a bigger picture question since it's on top of everyone's mind. I love to maybe just get a little perspective around how you guys were thinking about a scenario to the extent we do have a Biden White House, but a Red Senate, so probably don't see tax legislation change probably less stimulus. And related to that, you mentioned, the pickup in deal flow over the past couple of months, I think that's consistent with the broader M&A markets. But if credit and equity markets remain reasonable and either call it political outcome that could happen here, do you see anything that could change kind of the strong momentum in new deal flow?
No. Look, I think, you're right, which is – I'm not – by the way I'm not – I think both sides want to get some type of stimulus done, which I think is net positive for markets, including credit markets. I do think significant undoing the Trump Tax Reform is probably off the table or specific stimulus into blue States, it's probably off the table. We saw that obviously in some of the New York City in REIT stocks yesterday and that were significantly down. But on the corporate credit side keeping corporate tax rates as is it's probably positive for credit and positive for valuations. And so, I think, putting personal politics aside, the markets like – I think like the outcome of – or at least yesterday and today on pre-markets like the outcome of stability and knowing what the rules are, stability and unknowing what the corporate tax rates are. And, my guess is, is that. There will be some type of stimulus on both sides of the table.
Okay, terrific. And maybe just a follow up here, so pick income is obviously somewhere. So we've been focused in your picking commitment as a percent of your total investment income is very low to 3.2%. And so, I'm just curious if that's just a function of some of the portfolio positioning that you've spoken about just the health of the portfolio, or is there something else going on there as we think about moving forward?
Yes, so I think, first of all, pick income I think on a notional basis, Ian correct me if I'm wrong was only up like $100,000 quarter-over-quarter.
That's right, Josh.
And that was a function of, I think, two new names that pick components, Biohaven and Forescout in a full quarter of pick income on first channel of sprinkler, which were relatively small positions and those were not – none of that was related to restructurings. So those were related to investment choices we made. The activity levels on amendments were significantly down quarter-over-quarter. And so – I don't think there were any amendments in the last quarter that had put – that had – where we added pick income.
And so, I think that's a function of where we positioned the portfolio of pre-COVID. We're in the capital structure and quite frankly on a sector basis, I think, as we mentioned in our earnings script really we report our industry exposure by in markets served. But really when you look at our portfolio, I think, 75% of our portfolio is tech enabled business service as a software, which have very segregated revenues and decently variable cost structure. And so people have been able to kind of live through the volatility given that the nature and the structure of the businesses that we chose to finance.
Okay, terrific. I will leave it there. Thank you guys.
Great. Thanks. Welcome again.
Thank you. Our next question is from Robert Dodd with Raymond James.
Hi guys. Josh during – I think it's actually for Bo. You mentioned notable increase in sponsor activity at the end of Q3 and Q4. I mean that's consistent with what we've been hearing. But at the same time, obviously, Biohaven, Designer Brands, Centric, the more niche asset backed really good credit security, very high IRRs, which we can obviously see with the Centric Brands because it's already been realized. What – the sponsor type business tends to be a lower IRR maybe longer lived asset than the ABL stuff, higher IRR shorter lived asset.
Looking forward, I think it’s a tough question, what do you – what areas do you expect to see? And I'm not just talking about Q4, talk about 2021, et cetera, do you expect to see the most capital deployed into? Is the market shifting right now from what was more ABL during the tougher periods to maybe more sponsored in 2021? Or can you give us any thoughts on that?
Yes, so it's a great, great question. I'm not sure I'm going to have the greatest answer. How we've set up our business model is really to focus on multiple channels and investments in industries that we like to be – in investment types of industries that we like – that we think have good credit characteristics, i.e., because you don't even in the sponsor business even though they might be longer weighted average life, you don't really own a right tail. Like you're not going to make four or five times your money. And so you got to figure it out, you got to spend your time and truncate the left tail. And so that's when we think about our business, we think about looking for and prospecting for a deal that has a return profile that doesn't have a left tail.
And so that's built in – and then we've set up our business where we're kind of agnostic towards channels. And so, we're an agnostic towards sponsored channel or non-sponsored channel, stress rescue financing, healthy businesses, as long as that distribution is consistent and accessible. And on occasion we might take some probability of loss, but you got to have – really have a higher expected MOM. And so, I don't have a – I would have thought if you would have said in March or April, where was all of our activity going to be? I would have said all of our activity is going to be in rescue financings. And I think that quite frankly was offset by a ton of stimulus. And the fed either kind of threatening or actually participating in credit markets.
And so, hopefully, how we have our business set up is we don't have to – we're not levered to any one channel. And so because if we – obviously the world has changed and changes pretty quickly. On the margin I think that there are going to be more tail risk industries out there. Obviously real estate is one. We'll probably not do any real estate in the BDC because we do corporate lending, but that's an example one. Retail, I think, is continues to be in a world of hurt. And we probably can smartly deploy some capital there and continuing to do some asset based stuff, where companies have broken balance sheets through carving out specific assets, either through inventory or receivables.
So I think that will continue to be an opportunity, but I also think that the regular way, sponsor finance in our industries that we like will also continue to be an opportunity. So I know it answer your question. I guess the answer is we don't know. We're set up the cover works as a platform in a $47 billion asset manager in the credit space. We're kind of set up to capitalize and wherever it comes from. Bo or Fishy, do you have anything to add? And by the way, Fishy continues to be an active participant in business, so we make them join these calls. Bo and Fishy, do you have anything to add?
No, I mean, listen you're 100% right, Josh. The thematic approach and omni-channel approach allows us to be active. When each of those channels have muted activity like we saw in Q2 in the early Q3 in the sponsor M&A transactions, we saw that activity picked up the natural arc of gestation periods of deals means that you start seeing that activity really comes through in late Q3 and the pipeline in Q4, which we see. That was really pent-up and there was a lot of pent-up demand for M&A given where our asset prices are right now. So it's a very active environment. I think you're hearing that across the industry. I would expect and this would just be a guess that you would continue to see kind of normal levels of M&A going forward without some sort of dislocation, but we're also seeing a lot of opportunities across our other – direct to company retail ABL, so that the pipeline feels very balanced right now.
Yes, I'll just add, I mean, I think, a lot of what we do are core software business services. We did see a pretty good snapback in the last few months as far as activity goes and I expect that to carry into next year. So that should continue along with what everybody else mentioned, retail ABL, asset-based restructurings and the like.
Thanks, Fishy.
I appreciate that. I really appreciate that. It's a little bit of a crystal ball question, but I appreciate the color. Just one kind of follow up of – on the M&A activity and the sponsor activity, I mean, can you give us just a quick view on how pricing is? I mean, I presume spreads – spread widening didn’t [indiscernible] backway as it seems, but documentation, et cetera. Can you give us any quick comments there?
Yes. I mean like I'll quickly step in there. I think compared to pre-COVID, you're still seeing levels – leverage levels down modestly, better documentation than you were seeing pre-COVID. From a pricing standpoint, there's probably still a premium to pre-COVID, but that is definitely getting competitive and that is starting to tighten up.
Thank you.
Thank you. Our next question is from Finian O'Shea with Wells Fargo Securities.
Hi. Good morning. Thanks for having me. Just one question on for Josh or Ian, on the LIBOR swaps that was interesting color on the reversal coming up in the gains you've had? And obviously was an increasing strategy to have had replace going into the recession before that LIBOR was going down, but where things are now as these unsecureds roll-off soon, assuming you all replace those soon. Would you still execute that same strategy or structure? Would you still swap to LIBOR given it's essentially zero? Any color on that if that would change going forward?
Yes. Look our fundamental belief is that, we have the ability to underwrite, manage and take credit risk and manufacturer strong credit risk premiums. We don't really have the ability to figure out the macro. And so LIBOR – as you say LIBOR was close to ten to zero, that being said, there's arguably negative real rates right now, and there's negative nominal rates in Europe. So I don't, you should not think about LIBOR is a – I would not think about LIBOR as a floor. I'm not calling for negative rates, but you shouldn't think as zeros and absolute floor. Zeros are number just like negative 30 is a number. So, I would say we will continue to have, we'll look at it when we make that call, but we'll continue to have a bias where we think we can – we think we did something not well and have the skillset, and we continue, and we do some things not well or don't have a, we might do well. We don't think we have the skill set to do that well, which is the macro.
And so it tasked as a little came to us, would you stop hedging your foreign currency exposure by borrowing the local currency. And so the answer is independent of where you think there's going to be a reversion to mean or independent where you think are currency swap rates are – cross currency swap rates are, we probably want to do so, just because we don't have that skill set. So I would expect, we haven't talked about it for awhile, but I would expect that our general North Star remains unchanged. And I would – our LIBOR or swaps just to be clear, unlike our bank deal does not have floors. And so if LIBOR does go negative, our cost of funding is going to go down on our nodes, whether it's existing swaps. If there's a floor of zero on our bank revolver, but in our end if there's no zero.
Ian, do you have anything to add there?
No. I think Fin; you actually understand the concept anyway, because on day one when we enter into a swap, the NPV is zero. So they're not just revert back to the comments that Josh made about, where our skillset lies beyond that in terms of forecasting on a macro basis.
No. I thank you and appreciate. Actually, one more question popped up...
I know you get this, the one thing just for other people who might be listening, there's a significant correlation between when rates go down that there's all kind of economic uncertainty, right? Because as a policy matter, people are using new rates and monetary policy as a form of stimulus, and so the – and right now we basically have on our asset side, we have basically fixed – a fixed rate of return given our LIBOR floors. And so in the environments, when there is a ton of uncertainty and policymakers are pushing rates down, we probably have credit losses. And so we liked the benefit in that environment from the net interest margin experience, which we've massively – which we we've actually massively has helped us by 100 basis points or 110 basis points projected next quarter.
And so what we do give up is, we give up a massive risk on environments and we give up some ROE expansion if we have a whole bunch of fixed rate debt. The other thing I would say – the last thing I'll say on the subject is, another theme is like, is that our dividend to be argued excluding the environment we live in today, which is expected some credit losses as safer today than it was a year-ago. So because of the net interest margin expansion; and so I think that is one we have more net interest margin, than we've had it historically, which actually provides safety for our dividend and safety for future credit losses.
Sure. Thank you. And spillover, I don’t think you paid out the $0.50 in, I think first quarter. You're undistributed NII is already above where it was before that. Are we looking at another – are we looking at another special, special as you may call it or extra?
Yes. So I'll let Ian answer the second bit. It's a little bit of a bummer, right? We did that. We've tried to avoid doing large specials, when we put in the recurring supplemental dividend framework, two, 2.5 years ago. And then given that the level set earlier at $0.50, we ended up having friction costs and kind of growing the spillover income and growing unfortunately on a per share basis, the excise tax. And so we wanted to clean it out. I think we're basically back pre-cleanout. Is that right Ian?
Yes. At the beginning of this year, when we went to the board with the proposal, we were at $1.61 per share of undistributed income and at the end of Q3 we were at $1.55. So we're pretty much back there.
And so, I think we'll look at – correct me if I'm wrong, the plan is to look at where we sit on tax basis and looking at the 90% rule and look at how much of excise tax is a drag on earnings. And we'll go through the same work we did at the end of the year – at the end of this year.
Awesome. Well, thank you. Thanks so much and congrats on the quarter.
Great. Thank you. Hope you and your family are safe.
Thank you. Our last question is from Ryan Lynch with KBW.
Hey, Ryan.
Hey, good morning. Thanks for taking my questions. A lot of BDCs, I've talked about really positioning their portfolio, late cycle over the last several years, but not all BDCs portfolios have really held up as well as [indiscernible] has so far. And I know there's, you had mentioned, there's still a lot of credit risk in your portfolio, and we're still in the midst of a downturn, but so far you guys have grown book value meaningfully in 2020 in the midst of this downturn and have had actually one of your best ROE – net income ROE generation years, that you guys have had in the midst of this down turn. So I'm just curious, are you guys surprised how well your portfolio is held up in the midst of this downturn and how much value you guys have been able to create?
Yes. Look hindsight's always 2020, so I think we feel very good about where we are today and the portfolio today, I'm a little bummed that in the midst of, and again hindsight is 2020 and I've had these conversations with people, a little bum that we turned off our stock. We didn't buy enough bonds back in those moments. There is a little bum that we didn't buy back. We turned off our stock buyback program in middle of March to protect liquidity. I'm a little bummed that, we quite frankly, a whole bunch of value in Q2 and Q3 by being a little bit active, there was probably more opportunity to be had there.
But uncertainty was very high, and so it doesn’t give us a path for 2020 hindsight, I'm a little bummed. So I feel very good about what we were able to accomplish and how we protected the balance sheet and, but that all started with, I think protecting the balance sheet and it was only a decision on what assets we chose to finance. It was because there was some of our peers, who had financed similar assets, but they were – they got backed into doing on natural things because they didn't reserved for unfunded commitments.
They didn't think about draw downs and net asset value during times of volatility and what that meant for offense. And so I think it's a combination of – the ROE is this period or a combination of assets we picked the finance and positioning in the left-hand side of the balance sheet, but it's also how we positioned the right-hand side of the balance sheet to be able to make the business at minimum robust. But possibly anti-fragile where we were able to attack opportunities during times of volatility, which we've always talked about.
And so, I'm little surprise, yes, but I think if, what we thought about and how we thought about the business, and quite frankly I thought a lot of the disciplines we put into our framework ahead of the crisis allowed us to capitalize a little bit. And in hindsight, I wish we would have capitalized more.
Ian, Bo or Fishy anything?
I think that's right.
I agree.
Okay. Yes. Well done. You mentioned in some of your earlier comments, prepare remarks, some of the secondary opportunities that you guys have and the value you create in the second or third quarter. Looking to the fourth quarter, are there still any opportunities in those markets at all or given the kind of run-up in prices, is that kind of market kind of gone away at this point?
It feels like it's gone away. I mean, things are not obvious. So for example, the structured credit market is not as obvious to us on an opportunistic basis. I think there's some value to be had there, but given that it's kind of, I won't say outside the lane, but it's an adjacency, it's there's, it's not that screaming value that we're going to kind of go out of our lane. I would say, I think there's opportunities in regular way, direct lending, that we think of interesting. But we are positioning, look, the path of COVID is highly uncertain.
And we are, I think we are continuing to position our balance sheet to not saying that there's going to be more volatility to come. But if there's more volatility to come both from how much capital we have and how much liquidity to have to be positioned to lean into that volatility, if it does come, and so our balance sheet was, I think pretty well in position pre-COVID is actually in better position today, given we have more capital, we have debt equity's lower, basically the same amount of liquidity.
Ian?
No. I think you captured at that, Josh.
Okay. I just had one more. I think earlier you were talking about, Robert was asking about the kind of terms and structures on sponsored deals. I think you said they were maybe modestly better from leverage levels or documentation, and maybe a little bit better on pricing, but then maybe that's coming down.
Just curious your thoughts on, even if terms, documents, structures having materially improved since where they were maybe pre-COVID, would you still consider a new investment today versus a year or two ago, potentially a better risk adjusted opportunity, just because if you're making an investment into a new portfolio accounting today, you're at such an information advantage versus where you were a year or two ago, because you've had this recent, so you are seeing how this particular businesses is performing during a very severe downturn. So while the terms and structures may not have improved significantly, the risk adjusted return is better because of the information advantage you potentially have?
Yes. So I think that's a very valid framework, and a very valid argument. I think it all comes down to the underlying maybe [indiscernible] credit. And I don't think that you can underestimate the volatility in both our portfolios and how businesses perform was most definitely muted by the significant stimulus. And so you kind of got a window, but – and to how things performed, which I think you most definitely have this an informational advantage which is helpful in your underwriting. That being said, you had a whole bunch of stimulus through PPP loans or through just broad based stimulus that you – that tide kind of went out and then kind of got stopped.
Does that make sense?
Yes.
But I think your framework is a valid framework, which is yes, like you get to see, how cost structures behave? How management behaved? How sticky where the revenues in the backdrop of COVID? And then I would say plus at the backdrop of stimulus.
Yes. So I guess a couple of different factors there. One would be Government coming in and talking about the stimulus. Well, great. So, those are all my questions.
Great. Thanks, Ryan. I appreciate the time today.
Yes. Have a good day. I know it’s a busy day for you all. Thank you so much.
Thanks everyone.
Thank you. And this concludes our Q&A session. I would like to turn the call back to Joshua Easterly for his final remarks.
Great. We have a little bit of a history of wishing people happy holidays and the Thanksgiving is coming up. And so what I would say to people is, I think when the silver linings of COVID is, you know, people for better or worse, got to spend a lot of time with their family. For me, it's been quite frankly amazing. And so hopefully people take the time given all the strife in the world and on Thanksgiving, and really take the time and appreciate the things they have and figure out how to make the world a better place. Thank you.
Thank you. Ladies and gentlemen, this concludes today's program. You may now disconnect. Have a wonderful day.