Sixth Street Specialty Lending, Inc. (TSLX) Q4 2015 Earnings Report, Transcript and Summary

Good morning and welcome to TPG Specialty Lending, Inc.'s December 31, 2015, fiscal year-end 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 including with regard to TPG Specialty Lending Inc.'s proposal to acquire TICC Capital. 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 fourth quarter and fiscal year ended December 31, 2015, and posted a supplemental earnings slide presentation to the investor resources section of its website, www.TPGSpecialtyLending.com. The earnings presentation should be reviewed in conjunction with the Company's Form 10-K 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. As a reminder, this conference call is being recorded for replay purposes. I will now turn the call over to Joshua Easterly, co-Chief Executive Officer and Chairman of the Board of TPG Specialty Lending, Inc. Please go ahead, sir.

Thank you, Ashley. Good morning, everyone, and thank you for joining us. I will begin today with a brief overview of our quarterly and annual highlights and will then turn the call over to my partners, Mike Fishman and Bo Stanley, to discuss our origination and portfolio metrics for the fourth quarter and full year ended December 31, 2015. I would like to introduce Ian Simmonds as TSLX's Chief Financial Officer. Ian will discuss our quarterly and annual financial results in more detail. And I will conclude with final remarks before opening the call to Q&A. I am pleased to report solid financial results for the fourth quarter and full year 2015 with net investment income per share of $0.44 for the fourth quarter and $1.76 for the full year, the latter of which is on the upper end of our guidance of $1.63 to $1.79 per share. Net investment income exceeded both our fourth-quarter and full-year dividends of $0.39 per share and $1.56 per share, respectively, continuing our track record of over-earning our dividend on a net investment income plus net realized gains basis. Net asset value per share as of the year-end was $15.15 as compared to $15.62 at the end of the third quarter and $15.53 at the end of 2014. Net asset value per share movement during the fourth quarter was largely driven by unrealized losses related to widening credit spreads in the broader markets and continued volatility in the energy sector, both of which negatively impacted our investment valuations. The fourth quarter of 2015 saw continued widening of credit market spreads and risk premiums across asset classes due to concerns about global growth. LCD first-lien spreads widened by approximately 50 basis points and LCD's second-lien spreads widened by approximately 225 basis points during the fourth quarter. For the full year 2015, LCD first-lien spreads widened by approximately 80 basis points and LCD second-lien spreads widened by 400 basis points. In light of this, and based on fair value accounting principles all BDCs are subject to, we would be surprised if net asset value across the sector had remained stable. From an asset price perspective, the headwinds in credit in 2015 would suggest a year-over-year unrealized decline of 10% to 20% in net asset value for leveraged loan-oriented BDCs, assuming a five-year average loan maturity and depending on portfolio leverage and tranche mix. However, TSLX's net asset value per share only declined 2.5% year over year as a result of our first-lien-oriented and shorter duration portfolio. These qualities can be attributed to the private, illiquid nature of our loans, our control lender position, and our strong investor-friendly covenants. As energy exposure continues to be a topic front of mind of many, I would like to take a minute to discuss our investments in the sector. At fourth quarter ended our oil and gas exposure was approximately 3.2% based on fair value. We did not add any oil and gas positions during the quarter and our exposure remains limited to two portfolio companies, Mississippi Resources and Key Energy Services. Mississippi Resources, our largest oil and gas position, is an upstream E&P company in which we control 100% of the capital structure. We believe that our first-lien credit investment is supported by the company's proved, developed, producing reserves; low average cash lifting costs; and substantial hedges through early 2017, which will support cash flows for debt service. Our other oil and gas position is a $10.5 million fair value investment that is currently dollar one risk and includes important protection features, including an asset coverage test on appraised collateral value. Since our inception we have viewed our dividend as a liability that must be financed with real cash earnings and, therefore, we generally avoid distress-for-control opportunities where we have lower certainty of receiving cash interest. That said, as it relates to our investment strategy in the energy sector, we will opportunistically review situations where we can provide conforming first-lien reserve base loans. We expect to only focus on the upstream companies that have significant hedged collateral value at current price levels and are situated low on their respective cost curves. While the environment for energy has been challenging, it should be noted that we have generated a gross unlevered IRR of 39% on exited oil and gas investments to date and a gross unlevered IRR of 17% on exited and current investments across this sector. Moving back to our portfolio overall, during the fourth quarter we fully exited our investment in Milagro upon the consummation of the company's prearranged plan of reorganization. Our implied loan-to-value exit was 49% and our gross unlevered IRR was approximately 32%. We are also pleased to report that the A&P bankruptcy progressed as anticipated and that we were fully repaid on our investment during the fourth quarter. During the first quarter of 2016, we received a full repayment of one of our restructured securities related to IRG. This is denoted as the JL Secured Promissory Note in our schedule of investments. At the fourth-quarter ended, we had no loans on nonaccrual status. As announced in our last quarter's call, our Board of Directors declared a fourth-quarter 2015 dividend of $0.39 per share payable to shareholders of record as of December 31, 2015, which was paid on January 29. Our Board has also declared a first-quarter 2016 dividend of $0.39 per share, payable to shareholders of record as of March 31 on or about April 29. Now I would like to turn the call over to my partner Mike, who will walk you through our quarterly originations and portfolio metrics.

Thanks, Josh. I will give a quick overview of our fourth-quarter and full-year portfolio activity before passing it over to Bo Stanley to discuss our investment themes and originations outlook. Q4 was our second-strongest originations quarter since inception with gross originations of approximately $399 million. We syndicated approximately $115 million of these originations, resulting in new investment commitments and fundings of approximately $284 million. These investments were distributed across six new portfolio companies and three add-ons to existing portfolio companies. During the fourth quarter we had $154 million aggregate principal amount in repayments from four investment realizations, including the exit of our $60 million position in Milagro. Since inception through December 31, we have generated a gross unlevered IRR of 16.3% on exited investments, totaling approximately $1.2 billion of cash invested. Through our direct originations efforts, 87% of our current portfolio was sourced through non-intermediate channels. This enables us to control the documentation and investment structuring process and to maintain effective voting control in 81% of our debt investments. As of December 31, our portfolio totaled approximately $1.5 billion at fair value compared to approximately $1.4 billion as of September 30. At quarter end, 88% of our investments by fair value were first-lien and 96% of our investments by fair value was secured. In keeping with our theme since early 2014, we have primarily focused on investing at the top of the capital structure and our junior capital exposure remains below 12%. Additionally, since the beginning of 2013, we have reduced our exposure to non-energy cyclical industries from approximately 31% of the portfolio at fair value to approximately 7% at the end of 2015 and reduced our energy exposure from approximately 10% of the portfolio at fair value in late 2014 to approximately 3% at the end of 2015. The portfolio is broadly distributed across 46 portfolio companies and 20 industries. Our average investment size is approximately $32 million and our largest position accounts for 4.9% of the portfolio at fair value. At this point in the economic cycle we are focused on industries with low cyclicality and the ability to perform throughout credit cycles. Our largest industry exposure by fair value at quarter-end were to business services, which accounted for 21.2% of the portfolio at fair value, and healthcare, primarily healthcare information technology with no direct reimbursement risk, which accounted for 18% of the portfolio at fair value. The weighted average total yield on our debt and income-producing securities at amortized cost at December 31 was 10.1% versus 10.5% at September 30 and 10.3% at December 31, 2014. This yield will vary quarter to quarter as originations and repayments in any single quarter are idiosyncratic given our direct originations model. The weighted average yield of new investments made during the fourth quarter was 9.3% at amortized cost, which was lower than the weighted average yield at amortized cost of investments exited during the fourth quarter of 11.9%. This was due to the sizable repayments on several existing investments that had higher yields such as our $60 million investment in Milagro, which had an amortized cost yield in excess of 13%. Meanwhile, during the fourth quarter we underwrote investments with slightly lower weighted average yields, but also lower weighted average risk profiles such as Nektar, which Bo will discuss in more detail. With that recap of our portfolio activity, I would like to turn it over to my partner, Bo.

Thanks, Mike. I would like to begin by discussing our originations pipeline. We expect the current liquidity shortage--as traditional and/or undercapitalized lenders are unwilling or unable to underwrite and manage risk--to benefit middle-market lenders with strong underwriting capabilities and access to capital, like ourselves. January 2016 marked the lowest number of private equity deals completed for the first month of the year in more than a decade due to disconnects in buyer/seller valuations, resulting in a general unwillingness to transact. Given our deep relationships with the middle-market sponsor community and our track record of delivering over $2.4 billion of capital in sponsored transactions since our inception, we believe we are well-positioned to fill the developing void in the market. Through our discipline of match funding our assets and liabilities, we have created a structural advantage of long-dated capital, which in combination with the reduced market liquidity and wider credit spreads, could lead to higher net interest margins for our shareholders. In addition, we have the capability to opportunistically participate in secondary markets when outsized risk/return exists in sectors and/or companies in which we have a differentiated perspective. We believe the ability of TSSP and TPG-affiliated funds to co-invest alongside us will continue to enhance our ability to provide larger commitments and certainty of execution for our borrowers. Per the terms of our SEC Exemptive Relief, co-investments made by affiliated funds on the same economic terms and in the same part of the capital structure as TSLX. TSLX will continue to receive priority allocation on every US middle-market loan origination investment opportunity that our broader platform identifies. We believe our fourth-quarter originations results speak to the robust opportunity set for well-equipped capital providers like ourselves in the current environment, and we expect this trend to continue in 2016. Our investment in Nektar during the fourth quarter aptly illustrates our competitive advantage under the current market uncertainty. During the fourth quarter, TSLX led a $250 million senior secured notes transaction for the publicly-traded biopharmaceutical company with approximately $1.5 billion of market capitalization. Through our SEC Exemptive Relief, we were able to provide certainty of execution for the company through co-investments from our affiliated funds. Our sector expertise and diligence capabilities enable us to form a differentiated investment thesis and we structured an attractive risk-adjusted investment that included a non-callable feature. While we are opportunistic about the current market opportunity set, we remain highly selective and particularly focused on avoiding situations where asymmetrical downside risk, both credit and noncredit in nature, exists. We seek to mitigate credit risk by investing in companies that are scaled and relevant to their supply chain. As of December 31, our core portfolio companies had weighted average annual revenues of $128 million and weighted average annual EBITDA of $33 million. Our target borrower profile has inherent downside protection features that may include a high degree of contractual recurring revenues and/or hard asset value, depending on the borrower's industry and our investment thesis. As of December 31, our borrowers had, on average, 2.6 times interest coverage and 18% unlevered free cash flow yield to our last dollar invested. Noncredit risks that we seek to mitigate include interest-rate risk, foreign currency, and reinvestment risk, the latter of which is mitigated by call protection on 88% of our investments. We mitigate foreign currency and interest-rate risk by match funding our assets and liabilities. When we fund investments in currencies other than US dollars, we borrow on a revolver in local currency, as this provides a natural hedge on our principal value against foreign currency fluctuations. In the schedule of investments from our quarterly financial reports, we reflect the fair value of our foreign-currency-denominated investments in their local currencies so that changes in fair value can be assessed independent of currency fluctuations. At fourth quarter end approximately 95% of our income-producing securities were floating rate, typically subject to interest rate floors, and 100% of our liabilities were floating rate. In the case of our fixed notes investment in Nektar, we swapped our fixed interest income streams to floating. With that, I would like to turn it over to Ian to discuss our quarterly and full-year financial results in more detail.

Thank you, Bo, and good morning, everyone. We ended the fourth quarter and fiscal year 2015 with total portfolio investments of $1.5 billion, outstanding debt of $653 million, and net assets of $821 million. Our net investment income for the fourth quarter and full year 2015 was $0.44 and $1.76 per share, respectively. This is towards the upper end of our full-year guidance range of $1.63 to $1.79 per share. Our average debt-to-equity ratio for the quarter ended December 31 was 0.77 times as compared to 0.65 times for the previous quarter. As always, we remain highly selective in our investments and take into account both our unfunded commitments and our forward pipeline when managing our financial leverage. We maintain adequate liquidity with approximately $281 million of undrawn commitments prior to regulatory leverage constraints and we believe we remain match funded from an interest rate and duration perspective. We continue to evaluate additional ways to diversify our funding sources on an opportunistic basis and will only pursue them if they are in the best interests of our shareholders. As it relates to our leverage and the current investment opportunity set, our ability to employ co-investments from TSSP-affiliated funds, which combined have over $7 billion of dry powder, affords us the distinct advantages of driving originations independent of market cycles and of optimizing leverage to drive ROE. As we have been since our inception, we remain disciplined in our capital raising strategy and will seek to raise capital only if it's accretive on both an earnings and book value basis. As you can see on slide 8 of our earnings presentation, during the three months ended December 31, we had a number of factors impacting our net asset value per share. We added $0.44 per share to NAV from net investment income against the dividend of $0.39 per share, and we had $0.02 per share reduction in NAV from the reversal of unrealized gains and losses from the full realization of four investments during the quarter. There were two other factors impacting net asset value in the fourth quarter: $0.23 per share can be attributed to unrealized losses from widening credit spreads that Josh alluded to at the beginning of this call and $0.27 per share can be attributed to other unrealized losses, of which the majority, or $0.20 per share, was related to our energy investments. As a reminder, every quarter we have an independent valuation firm review 100% of our marks for investments that have been in our portfolio for more than 45 days. At quarter end, the weighted average performance of our portfolio was 1.4 on a scale of 1 to 5, with 1 being the highest, as compared to 1.5 for the third quarter of 2015. This speaks to the underlying stability of our portfolio. As discussed before, we have a stock repurchase plan that automatically purchases shares based on threshold prices beginning $0.01 below our most recently published NAV per share, subject to volume restrictions. Our Board has recently approved a renewal of the plan through the earlier of August 31, 2016, or such time as the $50 million repurchase amount has been fully utilized. No shares were purchased under this plan during the fourth quarter; 2,000 shares were purchased under the plan during the year ended December 31, 2015; and subsequent to year-end, we purchased approximately 86,000 shares under the plan for a total investment of approximately $1.3 million. This repurchasing activity reflects our high degree of confidence in the value of our portfolio. Put another way, we view this as an opportunity to repurchase a small portion of our book at a marginal discount to par at an approximately 7% discount to call price. We believe shareholders should view our stock repurchase plan as a sign of our ongoing confidence in the value of our assets. From a liquidity perspective, the 86,000 shares repurchased year-to-date was more than offset by the approximately 148,000 shares of TSLX issued on February 1 as part of our dividend reinvestment plan. Moving to the income statement on slide 10, total investment income for the quarter ended December 31 was $43.6 million. This is down $3.2 million, or approximately 7%, from the previous quarter, primarily due to lower prepayment fees and accelerated OID associated with pay downs that we experienced in our portfolio during Q3. Our PIK income component remains low at approximately 3% of total investment income for 2015. On slide 11, we have provided a more detailed breakout of our revenues. Our interest income was $39 million for the quarter ended December 31. This is up $2 million from the previous quarter, or approximately 6%. “Other Fees” was $1.5 million for the quarter compared to $9.1 million in the previous quarter. This revenue line will be uneven over time as it is generally correlated to the movements in credit spreads and risk premiums. In contrast to prior periods, when elevated levels of pay downs generally resulted in elevated levels of “Other Fees”, the investments that we exited during the fourth quarter had either lower embedded call protection due to their earlier vintage or had prepayment premiums that were earned in prior quarters, as was the case of our exit from Milagro. Despite this, and as a testament to the core earnings power of the portfolio and the optimization of balance sheet leverage, fourth-quarter annualized ROE on net investment income was 11.2%, which is right in line with our annualized ROE target of 10.5% to 11.5%. If risk premiums continue to widen, we would generally expect lower levels of repayments in our portfolio and lower “Other Fees”, but higher “Interest Income”. For the quarter ended December 31, net expenses were $19.7 million, which is up from $17.3 million in the third quarter after adjusting for the one-time charge of $3.2 million related to the third-quarter pay down of our SPV asset facility. During the fourth quarter, net expenses increased primarily due to higher interest expense as we increased our quarter-over-quarter leverage. Our management and incentive fees this quarter also reflect the continued voluntary waiver of base management and incentive fees related to our investment in TICC. In closing, the business has exceeded our dividend on an NII and NII plus net realized gains basis. For the three months ended December 31, we generated an annualized ROE based on net investment income of 11.2% and for the 12 months ended December 31, 2015, we generated an ROE 11.3% on the same basis. Over the intermediate term, and excluding the impact of LIBOR floors and possible rate increases, we expect asset level yields of approximately 10.5%, additional fees to contribute approximately 1%, and our cost of funds to be approximately 4%. This, combined with our target leverage ratio of 0.75 to 0.85 times, results in our target return on equity net of fees and expenses of 10.5% to 11.5%. Based on our December 31, 2015, book value of $15.15 per share, this corresponds to a range of $1.59 to $1.74 per share on net investment income, which compares to our annualized dividend of $1.56 per share. We continue to generate strong, consistent earnings driven by a high quality of income from embedded economics in our portfolio. Josh, back to you.

Thank you, Ian, and welcome to the team. A central theme underlying the results of 2015 and our successful track record since inception is our focus on identifying, mitigating, and managing risk in our portfolio. Despite the backdrop of volatility and dislocation in credit and energy markets, our investment framework going forward remains unchanged. We believe that the fair valuation of the portfolio, cycle-sensitive capital structure and sector selection, and control features and credit documentation are the foundations of sound risk management in our business. The trend since mid-2014 has been a general widening of risk premiums across credit asset classes. While we have reflected the spread widening in our calculation of fair value, from the perspective of our portfolio construction and asset management approach, our belief is that the US and broader global economies are generally healthy. Much of the market volatility we have seen is driven by concerns about China's growth and the global energy sector. However, the global spillover effects of a slowdown in China’s GDP are somewhat limited, with only 2% of the S&P 500 revenues exposed to China. As for the consequences of low oil prices, research highlights a $550 billion annual wealth transfer from oil-producing countries to oil-consuming countries, with the largest gains accruing to countries with low gasoline taxes, such as the US. We believe robust consumer spending, which drives two-thirds of US GDP, will continue into 2016 due to resilient labor markets, steady housing prices, low commodity prices, and less fiscal austerity. That said, we remain late cycle-minded in our investment approach and have shifted the capital structure and sector selection of our portfolio accordingly. Although we are optimistic about the US consumer, we are much less so on the traditional storefront retail model and believe therein lies an attractive opportunity for our business. We believe there is currently a step-function change in the pace of secular decline in brick-and-mortar retail as more consumers shift to e-commerce. Given the significant operating costs and hidden financial leverage in traditional retail models, we believe there will be opportunities for TSLX to provide asset-based lending solutions on the highest and most liquid portions of collateral to retailers. In the case of Sports Authority, we provided an asset-based loan and remain confident that our first-lien investment sits inside the liquidation value of the company's working capital assets. Let me turn briefly to an update on our involvement with TICC. As you may know, on December 22, 2015, TICC held a special meeting of shareholders and failed to garner sufficient support for its proposed sale transaction of its external investment adviser. We believe the result of this shareholder vote not only reflects a demand from TICC shareholders for better management and governance, but also heralds an inflection point for the broader BDC industry to build a culture of accountability and shareholder alignment. Since the December 22 meeting, however, TICC's stock price has drifted lower, due in part to an entrenched and conflicted Board that has not taken any meaningful actions to deliver shareholder value despite its own admission that change was needed. In light of continued inaction from TICC's Board, on February 3 we delivered a formal notice to TICC of our intent to nominate an independent candidate for election to the TICC Board and to bring a binding proposal in front of TICC's 2016 annual meeting to terminate the investment advisory agreement among TICC and the external manager, which would come to no cost to TICC shareholders. We share the broader sentiment that it's time for TICC to become a professionally-governed public company with an independent Board of highly-qualified individuals focused on maximizing shareholder value. As a TICC shareholder seeking to protect the value of our investment, we believe that if a manager consistently demonstrates the inability to create shareholder value, then capital should be returned to shareholders. We remain steadfast in our belief that a combination of our business with TICC is a strategic alternative that offers value to both sets of shareholders, and we remain willing to engage in discussions with the TICC board. In 2015, TSLX delivered to our shareholders a total return of 5.7%, which represented an outperformance of approximately 10 points versus the Wells Fargo BDC Index. And since inception, TSLX has delivered a total return of 47.3%, which represents an outperformance of approximately 23 points versus the Wells Fargo BDC Index. Despite our outperformance, we are disappointed in 2015 total return results given the higher ROE expectations of our business. In hindsight, which is always 20/20, we made certain decisions that did not result in a level of returns targeted by our original underwriting case. In a continued period of volatility and low growth, one should expect TSLX, and generally our sector, to outperform given the defensive nature of our portfolio, which is evidenced by consistent cash flows and on-average 50% LTV profile through our last dollar invested. We have been vocal over the past six months in highlighting the need to improve the corporate governance practices within our industry. And are encouraged by certain actions taken recently by a number of our competitors, including more widespread adoption of the 10b5-1 plans, which in our view is a strong way to facilitate capital allocation. While our goal is to continue to provide outsized returns for our shareholders, we are intensely focused on preservation of our shareholders' capital and will remain committed to the principles that have brought us here. Our priorities going forward remain employing our proprietary direct origination platform, focusing on less-liquid credit investments that have superior risk-adjusted return profiles, and making capital allocation decisions to serve the best interests of our shareholders. Our long-term focus continues to be the guiding principle behind our dividend policy, capital raising philosophy, ongoing stock repurchase programs, and our investment in human capital across our platform. We believe our competitive advantage is a combination of our people, the long-term nature of our capital, and our distinctive investment process of putting the collective wisdom of our human capital and our platform against the current investment opportunity set. As Bo discussed earlier, given our long-dated capital, we have a significant structural advantage versus much of the rest of the market, which in the face of volatility will provide us with two distinct opportunity sets: the ability to provide primary capital to larger issuers on attractive terms and the ability to opportunistically participate in secondary markets when outsized risk return exists in areas where we have an angle. With our competitive and structural advantages, we believe we are well-positioned for a productive period ahead. On behalf of the TSLX team, thank you for your continued interest in TSLX and for your time today. Ashley, please open the line for questions.

Thank you. [Operator Instructions] Our first question comes from Mickey Schleien of Ladenburg. Your line is open.

Thank you. Our next question comes from Derek Hewett of Bank of America Merill Lynch. Your line is open. Derek, you might want to check your mute button.

Thank you. Our next question comes from Chris York of JMP Securities. Your line is open.

Thank you. Our next question from Terry Ma of Barclays. Your line is open.

Thank you. Our next question comes from Jim Young of West Family Investments. Your line is open.

Thank you. Our next question comes from Jonathan Bock of Wells Fargo Securities. Your line is open.

Thank you. [Operator Instructions] All right, I’m not showing any further questions in queue at this time. I would like to turn the call back over to management for any further remarks.

Great. We appreciate people's time and, Ian, welcome to the dance, I guess. We appreciate people's efforts in understanding the story and we will speak to people in, I think, May if not before. Thank you.

Ladies and gentlemen, thank you for participating in today's conference. This concludes today's program. You may all disconnect. Everyone, have a wonderful day.