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Edited Transcript of TSLX earnings conference call or presentation 3-May-19 12:30pm GMT

Q1 2019 TPG Specialty Lending Inc Earnings Call

Fort Worth May 6, 2019 (Thomson StreetEvents) -- Edited Transcript of TPG Specialty Lending Inc earnings conference call or presentation Friday, May 3, 2019 at 12:30:00pm GMT

TEXT version of Transcript

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Corporate Participants

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* Ian Simmonds

TPG Specialty Lending, Inc. - CFO

* Joshua Easterly

TPG Specialty Lending, Inc. - Chairman of the Board & CEO

* Bo Stanley

TPG Specialty Lending, Inc. - President

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Conference Call Participants

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* Christopher Robert Testa

National Securities Corporation, Research Division - Equity Research Analyst

* Derek Russell Hewett

BofA Merrill Lynch, Research Division - VP

* Finian Patrick O'Shea

Wells Fargo Securities, LLC, Research Division - Associate Analyst

* Leslie Shea Vandegrift

Raymond James & Associates, Inc., Research Division - Senior Research Associate

* Richard Barry Shane

JP Morgan Chase & Co, Research Division - Senior Equity Analyst

* Ryan Patrick Lynch

Keefe, Bruyette, & Woods, Inc., Research Division - MD

* Terry Ma

Barclays Bank PLC, Research Division - Research Analyst

* Thomas Quinn Wenk

JMP Securities LLC, Research Division - Associate

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Presentation

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Operator [1]

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Good morning and welcome to TPG Specialty Lending, Inc.'s March 31, 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 issue its earnings press release for the first quarter ended March 31, 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 first quarter ended March 31, 2019.

As a reminder, this call is being recorded for replay purposes. I would now like to turn the call over to Josh Easterly, Chief Executive Officer of TPG Specialty Lending, Inc.

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Joshua Easterly, TPG Specialty Lending, Inc. - Chairman of the Board & CEO [2]

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Thank you. Good morning, everyone, and thank you for joining us. I will start with an overview of our quarterly results and hand it off to my partner and our President, Bo Stanley, to discuss our originations and portfolio. Our CFO, Ian Simmonds, will review our financial results in more detail, and I will conclude with our final remarks before opening the call to Q&A.

After the market closed yesterday, we reported our results for the first quarter of 2019. Net investment income per share was $0.41, and net income per share was $0.59, both exceeding our first quarter base dividend of $0.39. The difference between this quarter's net investment income and net income was primarily driven by unrealized gains of $0.11 per share from the impact of tightening credit spreads on the valuation of our portfolio and mark-to-market gains of $0.05 per share related to our interest rate swaps from the flattening of the forward LIBOR curve. Our Q1 results corresponded to an annualized return on equity on a net investment income and net income basis of 10% and 14.5%, respectively.

Reported net asset value per share at quarter end was $16.34, an increase of $0.21 compared to the prior quarter after giving effect to the impact of the Q4 supplemental dividend, which was paid during Q1. Net asset value movement this quarter was primarily driven by unrealized gains related to a partial recovery of credit spreads following year-end volatility and the flattening of the forward curve, as discussed.

Yesterday, our Board announced a second quarter base dividend of $0.39 per share to shareholders of record as of June 14, payable on July 15. Our board also declared a Q1 supplemental dividend of $0.01 per share to shareholders of record as of May 31, payable on June 28. We believe our dividend framework is an effective way to enhance shareholders' cash returns while satisfying RIC-related distribution requirements and preserving the stability of net asset value.

As part of our ongoing assessment of our optimal capital allocation for our business, yesterday, we announced a change to our existing $50 million stock repurchase plan. Instead of purchasing shares automatically when our stock trades at prices starting at $0.01 below our most recently reported net asset value per share, we will be doing so starting at $0.01 below 1.05x our most recently reported pro forma net asset value per share, which corresponds to a price of $17.15 based on Q1 pro forma net asset value of $16.33. Given our focus on efficient capital allocation and shareholder returns independent of what it means for asset growth and the implications of fee income for the manager, we believe we should be reinvesting on our existing portfolio when there is an ROE accretive -- when it's ROE-accretive and the payback period is short. It's our belief that with hindsight, our self-imposed constraint of repurchasing our stock at book value is no longer applicable given our differentiated portfolio and fee structure and most importantly coupled with the change in regulatory framework, which has transformed the earnings power of our business.

Circling back to our business. If we can positively impact the earnings profile of our business through efficient capital allocation in the form of stock purchases, we should do so. Our stock repurchase plan is based on the careful assessment of trade-offs between the de minimis near-term dilution on book value and the length of the payback period as well as reinvesting in our portfolio and foregoing the future opportunity to make new investments in a higher-spread environment. We've laid out our analysis on Slide 17 of our earnings presentation materials.

With that, I'll turn the call over to Bo walk us through our portfolio activity and portfolio.

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Bo Stanley, TPG Specialty Lending, Inc. - President [3]

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Thanks, Josh.

The deal environment in Q1 continued to be competitive given the record levels of capital raise for the direct lending strategy over the past few years. Meanwhile, on the supply side, broader M&A activity in Q1 was relatively subdued coming off a volatile year-end.

Our strategy continues to focus on sector themes and being opportunistic in areas that coincide with our platform's underwriting expertise. We aim to differentiate our capital in the space by leaning in on the capabilities and capital base across the TSSP platform. As always, we are guided by our investment discipline and downside orientation in order to construct a high-quality portfolio that performs throughout market cycles.

To that end, during the first quarter, we generated $179 million of originations across 4 new investments and upsizes to 4 existing portfolio companies. $27 million of originations were allocated to affiliated funds, and $7 million of originations consisted of unfunded commitments.

On the repayments front, Q1 was relatively quiet following an elevated repayment level during Q4 of last year. This quarter, there were $33 million of repayments across 2 full realizations and 2 partial investment realizations and sell downs, resulting in net portfolio growth of $112 million.

Turning to specific investment activity. Two out of our 4 new names this quarter were sponsor M&A transactions that intersected with our thematic focus where our ability to offer certainty of execution was a competitive advantage and our ability to create strong risk-adjusted returns for our shareholders.

Now I'd like to provide an update on a few of our ABL investments. On February 18, Payless filed voluntary petition for relief under Chapter 11 of the Bankruptcy Code given the continuing challenges facing brick-and-mortar retailers. Post quarter end, we were fully repaid on our loan, which resulted in an unlevered -- gross unlevered IRR of 18% on our investment. During the quarter, we also received full repayment of our Sears DIP loan in connection with the company's exit from Chapter 11. Subsequently, we've participated in the $250 million asset-based loan to support Sears go-forward operations. We've been a lender to the company since late 2015. Given our relationship and familiarity with the company's capital structure and its collateral, we believe we've created a strong risk-adjusted return opportunity for our shareholders.

Retail ABL continues to be one of our various themes given the ongoing secular trends and our platform's differentiated capabilities and relationships in this area. As the direct lending asset class has become increasingly competitive, we've continually developed and evolved our investment themes in order to generate a robust pipeline of strong risk-adjusted return opportunities. Given the pipeline generated through our direct originations platform, post quarter end, we've had approximately $150 million in net fundings. In broad strokes, these post-quarter fundings exemplify our focus on thematic originations and the power of the platform.

Turning now to our portfolio metrics and yields. The underlying credit quality of the portfolio is in good shape with no investments on nonaccrual status at quarter end. Portfolio composition has remained consistent quarter-over-quarter with 97% of investments being first lien on a fair value basis. We remain diversified across 48 portfolio of companies in 18 industries, with financial services and business services as our top 2 industry exposures at 20% and 18.6% of the portfolio at fair value, respectively. As a reminder, the vast majority of our financial services portfolio of companies are B2B-integrated software payments businesses with limited financial leverage and underlying bank regulatory risk.

At quarter end, nearly 100% of our portfolio by fair value was sourced through non-intermediated channels. This allows us to structure meaningful downside protection on our debt investments. To provide some numbers around this, at quarter end, we maintained effective voting control on 81% of our debt investments, averaged 2.1% financial covenants per debt investment and had meaningful call protection under our debt portfolio of 103.4 as a percentage of fair value as a way to generate additional economics should our portfolio get paid -- repaid in the near-term. At March 31, the weighted average total yield on our debt and income-producing securities at amortized cost was 11.6% compared to 11.7% at December 31. This slight decrease was primarily due to the downward movement in LIBOR on our floating rate portfolio.

With that, I'd like to turn it over to Ian.

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Ian Simmonds, TPG Specialty Lending, Inc. - CFO [4]

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Thank you, Bo.

Our portfolio grew at a measured pace in Q1 ending the quarter with total investments of $1.82 billion compared to $1.71 billion at year-end 2018. Total debt outstanding at quarter end was $742 million, and net assets were $1.07 billion or $16.34 per share, which is prior to the $0.01 per share Q1 supplemental dividend that we declared yesterday.

As Josh mentioned, our net investment income was $0.41 per share, and our net income was $0.59 per share. Given this quarter's net funding activity, our ending debt-to-equity ratio was 0.69x compared to 0.59x in the prior quarter. And our average debt-to-equity ratio during the quarter was 0.66x. Overall, this was a quarter where we started with low financial leverage and had limited activity-related fees, and yet we were still able to generate a 10% annualized ROE on net investment income and overearn our quarterly base dividend. Inclusive of the post quarter end net fundings that Bo discussed, we estimate our leverage today stands at 0.83x. Given our portfolio activity to date and the strength of our investment pipeline, we expect our average leverage to increase for Q2, which drives ROE expansion even in the absence of activity-related fees. More on this later.

Turning to our presentation materials. Slide 8 contains an NAV bridge for the quarter. Walking through the various components, we added $0.41 per share from net investment income against the base dividend of $0.39 per share. A tightening of credit spreads resulted in a positive $0.11 per share impact on the valuation of our portfolios, and there was a positive $0.05 per share impact to NAV from unrealized mark-to-market gains on the interest rate swaps on our fixed-rate debt. Other changes, primarily net unrealized gains from portfolio companies-specific events, resulted in a positive $0.03 per share impact.

Moving to the income statement on Slide 9. Total investment income was $52.5 million, down from $74.7 million in the prior quarter primarily due to the elevated level of activity-related fees earned during Q4. Interest and dividend income was $49.5 million, down $2.5 million from the previous quarter given a slight decrease in the average size of our investment portfolio. Other fees, which consist of prepayment fees and accelerated amortization of upfront fees from unscheduled paydowns, were $0.8 million compared to $21.2 million in the prior quarter, which experienced record-high repayment levels. Other income was $2.1 million compared to $1.5 million in the prior quarter.

Net expenses were $25.5 million, down from $29.7 million in the prior quarter primarily due to lower management and incentive fees. The weighted average interest rate on average debt outstanding was 4.7%, up 20 basis points from the prior quarter due to an increase in the average effective LIBOR across our debt instruments and a higher unsecured funding mix. Note that there's effectively a 1-quarter timing lag on the LIBOR reset date for our interest rate swaps. And therefore, the beneficial impact of this further LIBOR decrease on our interest rate swaps will roll through next quarter's cost of debt. Further, if we are able to continue reramping the portfolio at the measured pace that we have to date, we would expect the weighted average spread on average debt outstanding to decrease given higher utilization of our lower-cost revolver funding.

Regarding our liability structure. On our last call, we indicated that with respect to the upcoming maturity of our $115 million convertible notes, our base-case scenario is to repay those notes given the liquidity and low marginal cost of funding available under our revolver. This continues to be the case.

Taking into account post quarter end net fundings, we currently have significant liquidity with approximately $714 million of undrawn revolver capacity. Nevertheless, we continue to monitor the debt capital markets and would look to issue new unsecured notes if we are able to do so at a swap-adjusted price that results in minimal pro forma drag on our ROE.

Before passing it back to Josh, I'd like to provide a quick review of our ROE metrics. In Q1, we generated an annualized ROE based on net income of 14.5% compared to 5.3% in the prior quarter and an annualized ROE based on net investment income of 10% compared to 16.4% in the prior quarter. The quarter-over-quarter swing in ROE on net income was primarily driven by the fair value impact of our valuation and risk management practices, namely incorporating credit spread movements in the fair value of our debt portfolio and implementing interest rate swaps on our fixed-rate liabilities to match the floating-rate nature of our assets. The quarter-over-quarter change in ROE on net investment income was primarily driven by lower activity-related fee income in Q1 given fee income in the prior quarter was elevated. Over the trailing 12-month period, we've generated an ROE on net income of 11.7% with an average balance sheet leverage of 0.79x.

We've added Slide 16 to our presentation materials this quarter to isolate the impact of balance sheet leverage on the earnings power of our business. The table at the top of the page shows our unit economics based on annualized results for the first quarter. Below that, the sensitivity table illustrates for -- that for each asset level yield holding constant operating expense ratio, an increase in financial leverage corresponds to an increase in ROE. We know that this concept is relatively intuitive, so the sensitivity table is to really -- is really meant to help people calibrate the magnitude of leverage on ROE for our business.

Looking ahead to Q2. Based on the increase in our leverage from an average of 0.66x in Q1 to our estimate of 0.83x today, we would expect to experience approximately 70 basis points of annual ROE expansion even if we assume the same low level of activity-related fees and asset yields as Q1. Note that we generally wouldn't expect low repayment activity to persist even in higher-spread environments given idiosyncratic events for our borrowers, which drive portfolio repayments.

As articulated on our last call, based on our expectations over the intermediate term for net asset level yields, cost of funds and balance sheet leverage, we expect to target an annualized return on equity of 11% to 11.5%, which corresponds to a range of $1.77 to $1.85 for full year 2019 net investment income per share. Again, if the market environment allows us to operate at the higher end of our target leverage range for sustained periods of times -- of time, we would expect to drive up to approximately 250 basis points of incremental ROEs for our shareholders.

With that, I'd like to turn it back to Josh for concluding remarks.

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Joshua Easterly, TPG Specialty Lending, Inc. - Chairman of the Board & CEO [5]

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Thank you, Ian. To wrap up, we had a solid Q1 with strong momentum building into the second quarter. As some may know, this March marks the 5th anniversary of our IPO. And in our first 5 years as a publicly traded company, we delivered a total return of 99% for our shareholders, which represents an outperformance of 80 percentage points versus the Wells Fargo BDC Index, an outperformance of 79 percentage points versus the leveraged loan index and an outperformance of 32 percentage points versus the S&P 500. We're humbled by the ongoing support of our shareholder base, and we'll continue to focus on delivering the best possible shareholder experience.

Given our long-term shareholder orientation, we care deeply about the sustainability of the BDC sector. In that regard, we believe our sector is faced with a number of structural impediments that act as a constraint to effective corporate governance. These include the 3% Rule, Acquired Fund Fees and Expense Rule and certain '40 Act voting and quorum requirements, which together have limited the ability of shareholders to seek change in underperforming external management arrangements, resulting in persistent shareholder value destruction.

Earlier this week, we've formally responded to the SEC's request for comments on the proposed modifications to the 3% rule. In short, we believe the SEC's new proposal continues to mute effective corporate governance given the voting restrictions on any shares owned above 3%. The price of an equity security reflects the economic value of the security plus the value of governance, and therefore, there's limited incentives to acquire incremental shares above the 3% limit if the right of governance is not included. Our recommendation to the SEC, we believe, allow for effective corporate governance while upholding the investor protections as originally intended by the 3% Rule. Unfortunately, we understand why external managers of persistently underperforming BDCs would want to preserve the existing 3% ownership and voting limitations because these limitations effectively serve as a restriction for change, which we've seen across the sector. Our letter to the SEC, along with the presentation laying out our perspectives, are posted to the Investor Resources section of our website. We welcome anyone with comments or questions to reach out to me or our Investor Relations team.

With that, I'd like to thank you for your continued interest and for your time today. Operator, please open the line for questions.

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Questions and Answers

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Operator [1]

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(Operator Instructions) And our first question comes from the line of Leslie Vandergrift with Raymond James.

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Leslie Shea Vandegrift, Raymond James & Associates, Inc., Research Division - Senior Research Associate [2]

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Just first, in the prepared remarks, you discussed the M&A market in the first quarter was slower than fourth, and we saw that in a little bit of repayments. And I wouldn't expect it to stay that low over the long term. But just in the near term, what's your outlook there?

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Joshua Easterly, TPG Specialty Lending, Inc. - Chairman of the Board & CEO [3]

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Great. Hey, Leslie. Good morning. I'll turn it over to Bo. I think generally, when there's a lot of volatility, M&A takes a pause given that sellers and buyers have a hard time kind of reaching a price agreement. So you would expect as we're in a lower kind of volatility environment or have been in Q1 and Q2, you would see that M&A starts picking back up. But Bo, do you have anything to add?

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Bo Stanley, TPG Specialty Lending, Inc. - President [4]

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Yes, and that's exactly right. We saw a pause in late Q4 with the volatility that carried on into early Q1. We saw a marked pickup in mid-Q1, and that's continued into Q2.

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Leslie Shea Vandegrift, Raymond James & Associates, Inc., Research Division - Senior Research Associate [5]

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And then on a couple of the portfolio investments. First, on IRGSE, just -- there's a revolver there. I mean, it's small. It's not a large investment, but there's a revolver there that keeps popping back on to the Schedule of Investments. Is that something -- is there a reason the repetitive name for that or why it keeps -- one quarter, it's there, one quarter...

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Joshua Easterly, TPG Specialty Lending, Inc. - Chairman of the Board & CEO [6]

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Yes. Hey, Leslie. So yes. Look, we continue to make -- obviously, its one of the investments has struggled, we've continued to make investments in the business, including a driving school. And so we've -- there's been net investment in the business as we continue to kind of evolve that business plan and continue to kind of drive what we hope to be a good investment, although it's taken longer and it's been harder than we expected.

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Leslie Shea Vandegrift, Raymond James & Associates, Inc., Research Division - Senior Research Associate [7]

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Okay. And on the Transform SR Holdings, the new Sears name, you went -- you got through the process with the $25 million DIP and now it's a $75 million ABL. Can you talk to me about kind of the investment thesis there, where do you see the value going forward with Sears and the structure you have on that?

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Joshua Easterly, TPG Specialty Lending, Inc. - Chairman of the Board & CEO [8]

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Yes. So it's the same thesis with -- specifically with Sears and generally with all of our asset-based loans, which is quite frankly, this doesn't say anything about the prospects of any of our retail asset-based loans, but we underwrite them to liquidation value. I think our last dollar is 80% of NOLV of liquidation value of the inventory, which what was -- which would hold up very, very well, and when most of the stores were liquidated in the old Sears format. So again, this is not commenting on Sears' specific prospects. We continue to believe that all brick-and-mortar retailers are extremely challenged. But you would expect -- we underwrite these transactions to a liquidation given the secular challenges and the volatility of earnings and the fixed cost structure that exists in all brick-and-mortar retail. So it's actually very similar on a structured basis with the same protections and borrowing base mechanism that you had in advanced rates that you had in the last Sears deal.

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Leslie Shea Vandegrift, Raymond James & Associates, Inc., Research Division - Senior Research Associate [9]

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And on the comment letter to the SEC that you mentioned. I don't see it on there, but is it -- do you have that -- is that out on the public forum for SEC or is that one of the private submission?

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Joshua Easterly, TPG Specialty Lending, Inc. - Chairman of the Board & CEO [10]

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So first of all, it's not -- there's 2 pieces of material. You should read it. It's a great read, if I have to say so myself. It is -- there is a comment letter and there's a presentation. Both of those were submitted to the SEC. Both are available on the -- publicly on the SEC website. It was posted yesterday, and then it is also on our website in the Investor Resources section presentations on top of the Presentations, both the letter and the presentation.

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Leslie Shea Vandegrift, Raymond James & Associates, Inc., Research Division - Senior Research Associate [11]

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Okay. And then just on the last question there on the repurchase plan, on the change to go from being able to buy back shares at under 1.05 NAV. So I guess my question, first of all, what prompted the need for this? I mean, since IPO, I think 11 days you trade below 1.05 NAV. So what was the push for that? And also, what do you think your stock does if it creates interim NAV volatility?

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Joshua Easterly, TPG Specialty Lending, Inc. - Chairman of the Board & CEO [12]

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Yes. So here's how we think about it. So I don't think anybody asked JPMorgan quite frankly, "why are you buying back stock above book value?" I think the BDCs, given the regulatory framework, has massively changed. That book value is less meaningful versus kind of what's accretive or dilutive to return on equity and on ROEs of business and what are the payback periods. And so I think over the last kind of 6 or 7 months, we have been talking about it as a group and we tend to think -- we tend to approach things in a very intellectual, kind of honest and rigorous framework. And if we were -- we said to ourselves, look, if we thought the right price was book value and the earnings power of the business has structurally changed, shouldn't we think about making an adjustment to the purchase price on the 10b5-1 Program. And quite frankly, people in this space have not bought back shares even if it's massively below book value because management teams don't want to forgo the opportunity for fees for their external manager. That is the only reason, quite frankly. Maybe it's cynical, but it's the only reason why I can think of whether or not they do that. And our view is forget about the fees, the possible fees to the external manager. Keep on driving ROEs, keep investing in the business, create an efficient capital structure, and the payback periods are very, very short. I think the payback periods are 7 months, which anybody -- if you said there's a 7-month payback period on investment, we would think it's very short, where the additional ROE accretion given the change in both funding mix and leverage offsets the de minimis dilution to net asset value. So I think that the -- we continue to push ourselves to think about the appropriate capital allocation framework for our shareholders. And so it -- you're exactly right. Where the stock has traded, maybe it doesn't matter. But at some point, it will matter or might matter and we should be -- we should put our shareholders in a position to benefit by being proactive and having frameworks -- having a framework that proactively creates value for our shareholders. Is that helpful?

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Leslie Shea Vandegrift, Raymond James & Associates, Inc., Research Division - Senior Research Associate [13]

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Yes. Thank you. And I guess just last one, I've missed it in the prepaid remarks. What was the spillover income at the end of the quarter?

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Ian Simmonds, TPG Specialty Lending, Inc. - CFO [14]

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Leslie, it's Ian. It's $1.19 per share. And I know through prior questions that you'd had, you've always focused on the components of that and the distributable earnings. And there's some helpful disclosure that the team has put into Note 12 in our Q, and you'll find that on Page 42.

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Operator [15]

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And our next question comes from the line of Rick Shane from JPMorgan.

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Richard Barry Shane, JP Morgan Chase & Co, Research Division - Senior Equity Analyst [16]

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I just have one quick question. When we're looking -- when you're talking about the converts maturing, sounds like the strategy is just to pay debt down on the revolver for now. I'm curious how the rating agencies look at that and the opportunity to extend your maturities through future unsecured note offerings instead.

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Joshua Easterly, TPG Specialty Lending, Inc. - Chairman of the Board & CEO [17]

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Ian?

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Ian Simmonds, TPG Specialty Lending, Inc. - CFO [18]

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Rick, I think we had had conversations with the rating agencies last year around what our range of unsecured versus secured mix is going forward. And as you saw us delever through the end of 2018, that mix shifted dramatically towards unsecured. So it's probably at the high end of where we thought our unsecured mix would be, as we re-lever through this year. And even if we do end up refinancing the 2019 notes through our secured facility, we're still going to be well within the range that we talked about with the rating agencies. But your question is well-crafted because it's something that we do focus on. I think that Josh's -- one of the comments in Josh's prepared remarks, we're not just going to go out to the market and take a transaction that's available. We want to make sure it's not going to impose significant ROE dilution as a result of changing the mix of funding. So it's something that we basically balance. And I think even in our prepared remarks, we talked about being opportunistic on the funding side as it relates to unsecured debt.

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Joshua Easterly, TPG Specialty Lending, Inc. - Chairman of the Board & CEO [19]

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Yes, I guess -- that's exactly right. Two other comments. One is that we have rating agency reviews throughout the year, including in the first quarter. We -- the comments we made on our Q4 earnings call and this earnings call are pretty consistent. So the rating agencies -- you can rest assured, we've had discussions with the rating agencies regarding this issue, and I would expect no adverse change because, a) we've obviously continued to have dialogue with them; and b) it's consistent with our historical policies and what's communicated to them. The second thing I would say, which is the -- we said this before, issuing an unsecured convert is very difficult in my mind for us, I think as the earnings power -- the convert market typically looks at historical vol. And the historical vol I think is going to be lower than the future vol because the earnings power has structurally changed across the sector. So you will not get the benefit of that in the coupon. And so put it in another way, I think what we've said is if you issue -- if we get to the 1.25x debt-to-equity ratio, which I'm not saying we're going to get there anytime soon, earnings per share is at -- stands at $2.25 to $2.35 range and if multiples hold, it feels like you're giving a pretty valuable option that didn't exist prior to the regulatory change. And so I think what we're really -- unless that perspective changes in the convert market, we're really focus on the unsecured market versus the revolver market and the impact on ROEs. And we feel very good about our retaining and keeping our IGratings given the performance of the business.

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Operator [20]

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And our next question comes from the line of Ryan Lynch with KBW.

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Ryan Patrick Lynch, Keefe, Bruyette, & Woods, Inc., Research Division - MD [21]

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First one, I just wanted to follow back on the buyback commentary. So just wanted to get a little more thoughts around why you set the buyback at 1.05 of book. You mentioned the small bit of dilution, which would create a 7-month sort of payback period based on the earnings growth. So if that's the case, why not set it at a higher level at 1.10 of book value when I think all it would really do is give you the same amount of accretion or the same amount of earnings accretion but a little bit more book value dilution and just expand that payback period a little bit? So why not set it higher, number 1? And then also, why have it as a programmatic program? Why now have it maybe more opportunistic? And just wanted to get your thoughts behind that because in an environment where you're trading, where TSLX is trading closer to book value, I would assume that, that's going to be a very distressed environment given the nature of how your stock price has traded historically, which would also mean it's probably a very attractive environment for deploying capital. So the second part would just be why is it a programmatic one versus maybe more opportunistic one where you guys can have some discretion?

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Joshua Easterly, TPG Specialty Lending, Inc. - Chairman of the Board & CEO [22]

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Yes. So let me answer the second question first because I think it's easier or it's on top of my mind. Why not discretionary versus programmatic? You can only look to the sector and see on the discretionary ones, how much actually people have bought back stock. The open-window period for us given our conservative nature is about 3 weeks. And so the idea that we can actually -- we open up our open window 4 days post -- 3 days post quarter earnings and close it 3 weeks thereafter, the idea that we're going to kind of hit -- we're lucky enough to hit the window and do something of size for our shareholders, I think is -- the probability is very, very low. So did I answer that question? And then as it relates to the...

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Ryan Patrick Lynch, Keefe, Bruyette, & Woods, Inc., Research Division - MD [23]

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Yes. That make sense.

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Joshua Easterly, TPG Specialty Lending, Inc. - Chairman of the Board & CEO [24]

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As it relates to the -- I think your point regarding the correlation between where the stock is trading and the opportunity for reinvestment spreads I think is a good one. And so how much are we forgoing when there's volatility, when the 10b5-1 program is getting hit, how much are we forgoing to invest and reinvestment -- to invest in a higher reinvestment spread environment, that got into the exact sizing of the program. And so we don't think we're giving up that much flexibility at a $50 million program. If we had a $300 million program on, we'd obviously be giving up a lot of flexibility and giving up a tool to create ROEs in a higher reinvestment spread environment. The why not 10 -- why not 1.10 versus 1.05? The answer is quite frankly, the payback periods are shorter at 1.05. We thought we needed to walk before we ran for this marketplace. We're a little bit of an odd duck compared to the sector in general because people don't even buy back stock below book value. And so we just thought that it was a good idea of walking. And over time, we'll evolve it to find -- to optimize the right, again, the right capital allocation policy for our shareholders. But my guess is, if I would've came on today and said, "Great news, 1.10 buyback, diluting shareholders," we -- some of you may applaud us for being innovative and thoughtful and putting shareholders first, and some of you might have thought that we're -- that we spent too much time in San Francisco, which we are today, and doing things that we shouldn't be doing. But I think that is -- it's a measured framework.

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Operator [25]

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And our next question comes from the line of Terry Ma with Barclays.

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Terry Ma, Barclays Bank PLC, Research Division - Research Analyst [26]

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So just looking at the additional fee income component in your unit economics. It's been pretty consistent historically. But I guess, just looking out as you ramp your leverage and grow your asset base, would you still be able to generate the same level of fee income?

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Joshua Easterly, TPG Specialty Lending, Inc. - Chairman of the Board & CEO [27]

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Yes. I mean, look, I think what you had was you had -- if you take a step back and kind of think about the big picture, Q4, we had a lot of fee income. We put forward future earnings, delever the book. And then we happen to be -- and that happened early in the quarter. And then in -- at the end of Q4, you had a point of volatility that were -- you didn't have any churn in the book, and that churn usually creates fee income. At the same time, we started off at a lower leverage ratio. And so we would expect -- I think fee income was about 60 basis points this quarter. Typically, it's 1.8 -- 180 basis points. So it was about 1/3 of what it historically has been since our IPO. So I would expect that as volatility slows, we'll find the right -- the business will find the right equilibrium between growing into leverage and some natural churn in our books. But as the quarter stands today, we've made a lot of progress on net fundings. We've had about $150 million of net fundings. I think on Monday, we'll have $180 million of net fundings. My guess is we'll see some churn in the quarter, but we really haven't seen any yet. And so we'll at some point get a -- the right -- We're pretty close to feel like getting the right kind of equilibrium between portfolio growth and churn. I think when you take a look back, this was the lowest level of payoffs in last 5 years.

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Operator [28]

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And our next question comes from the line of Christopher Testa with National Securities.

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Christopher Robert Testa, National Securities Corporation, Research Division - Equity Research Analyst [29]

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Just wanted to talk a bit about our ABL. Obviously it's been an area of much success for you guys. With all the retail bankruptcies in the first quarter being longer than all of last year, I'm just wondering if the environment ever gets so bad that it kind of give you any pause about getting more heavy into the space?

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Joshua Easterly, TPG Specialty Lending, Inc. - Chairman of the Board & CEO [30]

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Chris, look, the -- what really matters is, is how we think the inventory will liquidate as it compares to what -- where we're lending against it. And so what we've seen is given that the consumer is in very good -- I think don't conflate that the consumer is not in good health versus the -- what's happening in retail. That has historically been the correlation. Retail goes as well as the consumer. That is not the -- that's not what's happening here, right? Consumer is in a good health. There is a business model issue and a structural issue with retail brick-and-mortar stores given their fixed cost base and given the disintermediation of both kind of fast brands and plus Amazon and omnichannel business models. And so it's really the liquidation value of the inventory. And the liquidation value of the inventory has held up great. So we continue -- not that we're rooting against our clients, but we continue to hope for a decent amount of structural change so we could provide capital and provide -- be a solution provider into that space. And quite frankly, the liquidation values have continued to hold up very, very, very well. And I think you are exactly right. I think you had more unit closings year-to-date than you had all of last year, and that was mostly driven by, I think, our client, which was Payless.

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Christopher Robert Testa, National Securities Corporation, Research Division - Equity Research Analyst [31]

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Got it. Okay. Now that's helpful, Josh. And kind of sticking with theme on ABL. If that stress does continue at the kind of the pace that it's been at, do you think that, that actually portends to maybe actually higher spreads that you are able to achieve or is that something that you think is going to stay in the L plus 7, L plus 8 range where you guys typically have been making these loans?

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Joshua Easterly, TPG Specialty Lending, Inc. - Chairman of the Board & CEO [32]

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Yes. I mean -- so we should -- the answer is there will continue to be some competition in capital formation. And so I don't see spreads massively increasing, but there is a massive difference between spreads and total returns given how the asset class behaves, given corporate action, given upfront fees, given the duration of the asset class. And so I think our retail -- and people can correct me if I'm wrong, but I think our retail ABL strategy has generated close to 20% IRRs, 22% IRRs, they did correct me, since inception. And so obviously, we haven't been charging LIBOR 1,800 spreads. So the other thing I would say is that, look, this is a very tough business model for the manager and the GP, which is just a framework for people which is you -- if you think about the business model and if the panacea is that I can put out $100 of capital that stays out for 5 years and I can continue to grow my business even if it's a 10% IRR, that's very good for the manager. If I put out $100 of capital at 20% IRRs for 18 months, that is not very good for the manager but very good for the shareholder. And we continue to do things that are very good for the shareholder.

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Christopher Robert Testa, National Securities Corporation, Research Division - Equity Research Analyst [33]

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Got it. No arguments there. And I know you had mentioned in the prepared remarks too that a lot of your financial services composition is kind of B2B and a lot of technology. Given that banks are investing more and more in technology, especially as they deal with some really high efficiency ratios, just wondering if you're seeing the opportunity set there kind of expand to do more kind of fintech sort of investments and things that directly serve banks?

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Joshua Easterly, TPG Specialty Lending, Inc. - Chairman of the Board & CEO [34]

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Yes. So -- and I'll turn this over to Bo because he's kind of our fintech guy. We have a -- you're right, our portfolio, financial services portfolio is really fintech-oriented, and it's really integrated the combination of payments plus software predominantly on the B2B side. And we continue to like that area. We continue to be a very, very deep into that sector. I know that sector quite frankly very, very well, where we -- that allows us to add value to the ecosystem and sponsors that we do stuff in that business, we do stuff in that sector. But Bo, anything to add?

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Bo Stanley, TPG Specialty Lending, Inc. - President [35]

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No. As Josh mentioned, this has been a thematic focus of ours over the last 3 to 5 years, I think long before people started to focus on it. And the thesis was BTB payments and the intersection of software and BTB payments specifically was a decade behind where the consumer was from the adoption standpoint on the payment side. So there's a tremendous amount of embedded growth and very resilient business models that we can lend to. So we become thought leaders in the space, continue to focus on direct outreach to companies. And when that intersects with our sponsor effort, it's been a tremendous amount of flow for us. I think we put out $1 billion in the theme across the platform over the last 5 years, and it'll be continued -- it will continue to be a focus. And you're exactly right, banks are more and more focused in the space, which is creating opportunities as well.

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Christopher Robert Testa, National Securities Corporation, Research Division - Equity Research Analyst [36]

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And Ian, I just want to double check something you pointed out. What was the difference in the prepayment income this quarter compared to last?

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Joshua Easterly, TPG Specialty Lending, Inc. - Chairman of the Board & CEO [37]

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A lot. No. Ian will give you the exact amount.

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Ian Simmonds, TPG Specialty Lending, Inc. - CFO [38]

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Prepayment income last quarter was about $21.2 million. And it was about $1 million this year -- this quarter, very significant.

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Christopher Robert Testa, National Securities Corporation, Research Division - Equity Research Analyst [39]

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Got it. Okay. And that includes the fees and the OID acceleration, right?

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Ian Simmonds, TPG Specialty Lending, Inc. - CFO [40]

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That's right.

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Christopher Robert Testa, National Securities Corporation, Research Division - Equity Research Analyst [41]

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Okay. And last one for me and I'll hop back in the queue. Just more of a general question, are you guys seeing more and more of the kind of poor terms and sort of trapdoors creep into the core middle markets from -- what used to be just confined to the syndicated market and upper tier of the middle-market. Are you seeing that same sort of stuff, cov-lite or collateral dilution creep into, say, $50 million EBITDA companies and the like?

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Joshua Easterly, TPG Specialty Lending, Inc. - Chairman of the Board & CEO [42]

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Yes. That trend has continued. I think that the -- it's a continuation of sort of poor underwriting standards and poor documentation standards. As different managers, you have different experiences. And so that trend has continued. And I wouldn't say that it's accelerated over the last couple of quarters, but it has definitely continued.

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Operator [43]

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And our next question comes from the line of Chris York with JMP Securities.

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Thomas Quinn Wenk, JMP Securities LLC, Research Division - Associate [44]

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Tom Wenk in for Chris York this morning. Just one question for Josh or Bo regarding your investment opportunity set. You guys have been successful sourcing and underwriting special situations and unique investments that come with a bit of complexity. So given this focus or given this success, we ask you guys whether you have an interest or if you've ever really thought about extending financing solutions to companies in the expanding cannabis industry.

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Joshua Easterly, TPG Specialty Lending, Inc. - Chairman of the Board & CEO [45]

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Yes. That's a great question, given that we're sitting here in San Francisco. The answer is I don't think we're willing to take that reputational or regulatory risk. I think it's still Schedule I. And by the way, we've been approached. I think it's still Schedule I drug on a federal basis. We -- and there are interstate commerce issues. The second is, is that quite frankly, we have a large private fund complex that I think would probably take a view on this. And so the answer is we've been approached. We have passed and it's probably not something for us. I don't have a view on the sector and quite frankly don't have any -- obviously, I'm not a user of the product, so I don't have a view on if it's an investable sector from a unit economic basis. I do have a view that it's not investable from a reputational standpoint. All right. Tell Chris, I think Chris is out doing some public service stuff. So please we wish him well on that and thank him for his efforts.

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Operator [46]

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And our next question comes from the line of Finian O'Shea with Wells Fargo Securities.

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Finian Patrick O'Shea, Wells Fargo Securities, LLC, Research Division - Associate Analyst [47]

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Can you talk about the origination mix this quarter on sponsor M&A, new-money deals? It looks pretty dominant there, where L + 650, including OID. Is this kind of one-off -- are these kind of one-offs where we saw a good risk-adjusted return or does this maybe represent more of what you see as you lever up higher?

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Joshua Easterly, TPG Specialty Lending, Inc. - Chairman of the Board & CEO [48]

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Yes. Look, I'll make it -- so on Vita Bidco, obviously, is that should be a footnoted investment. So the return's much higher. So as you know how our Schedule of Investment works, there's some where there's a small revolver or a first out piece and there is, subject to skim. And so I think you're not seeing the total economics there. And then, Finn, you were breaking up a lot. I think you also asked just on the sponsor side. I would say post-quarter end, there's been a decent amount of non-sponsored business, including what's been out in the public, which is including our investment in Barneys, our investment in a specialty pharma company. And so it's been a bit of non-sponsored and sponsored business. And post quarter end, there's been a decent amount of non-sponsored business.

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Joshua Easterly, TPG Specialty Lending, Inc. - Chairman of the Board & CEO [49]

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It's muffled, so it's very hard to hear.

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Finian Patrick O'Shea, Wells Fargo Securities, LLC, Research Division - Associate Analyst [50]

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Sorry about that. I hope you hear me better in this one maybe. But I'll just ask one more on your fundraising trends and activity outside of your BDC. Are you raising more in direct lending capital?

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Joshua Easterly, TPG Specialty Lending, Inc. - Chairman of the Board & CEO [51]

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Yes. So it's a great question. We don't really raise any capital in direct lending capital or have done so historically, so just to give people -- which we think is a huge benefit to the platform. We have a direct middle-market lending fund in Europe. As people may or may not know, it's hard to do non-U. S. borrowers above from a regulatory standpoint, from a tax standpoint in the BDC. Non-U. S. investors have withholding tax as it relates to income where they don't -- for non-U. S.-domiciled companies, which they don't have withholding tax on the core business. And so the only really separately dedicated focus, direct middle-market lending fund is in Europe. We have a multi-strat credit fund that coinvests on bigger opportunities with TSLX. That coinvest is subject to TSLX getting whatever it wants on a deal first. And so it's not problematic. And so it gives the flex-up but not subject to the flex-down for TSLX shareholders. And then the last thing is we have raised a kind of a structured, more down the capital structure fund to provide capital to middle-market companies that's deeper down the capital structure, and those typically have large noncash pay component that would not be appropriate for TSLX shareholders given that we view the dividend as effectively a fixed charge liability. But we don't -- we view -- we have to think about the world in 2 ways, at which we think scale is the enemy of returns because you're competing against the higher of the leverage loan market. But we do need scale because on occasion, there's a great opportunity like Ferrellgas or other opportunities where you need capital and scale. And so we've historically done that through our private funds that -- but those private funds are not dedicated direct lending funds and come behind TSLX in the allocation process.

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Operator [52]

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And our next question comes from the line of Derek Hewett with Bank of America Merrill Lynch.

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Derek Russell Hewett, BofA Merrill Lynch, Research Division - VP [53]

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I guess first, I find the revised buyback policy actually quite refreshing, so I think -- so congrats on putting a spotlight on that issue. That said, I guess this would be for either Josh or Bo. I think given that pro forma leverage, I think you guys said it was about 0.83x at this point. What do you think you'd need to see to increase leverage to the kind of that 0.9 to 1.25 target range that was called out following regulatory reform?

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Joshua Easterly, TPG Specialty Lending, Inc. - Chairman of the Board & CEO [54]

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Yes. Great question. I think it feels like -- look, things can change. It feels like we're on our way. I don't think we'll be at 1.25 by the end of the year, but it feels like we're on our way and directionally headed that way. It feels like we're a little bit better situated than we were at Q4. And that the sense is that if there is churn and financial leverage is hurt, we'll have an increase in fee income that supports our ROE.

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Bo Stanley, TPG Specialty Lending, Inc. - President [55]

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That's right.

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Joshua Easterly, TPG Specialty Lending, Inc. - Chairman of the Board & CEO [56]

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I mean, the good news and the bad news about this quarter quite frankly is -- the good news is, is that with no fee income and low financial leverage, we over-earned our dividend and we had a 10% ROE and then a 14.5% ROE on a net income basis. There is a lot of latent earnings in the book as we grow leverage given where we are. So that -- I think that's a good news as well. The bad news is obviously is that it's not as good as a headline quarter you might've had previously. But I think the good news is that there's a lot of latency in the earnings. Bo, anything there?

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Bo Stanley, TPG Specialty Lending, Inc. - President [57]

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No. I think that's exactly right.

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Operator [58]

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And that concludes today's question-and-answer session. So with that, I'd like to turn the conference back over to CEO, Mr. Josh Easterly for closing remarks.

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Joshua Easterly, TPG Specialty Lending, Inc. - Chairman of the Board & CEO [59]

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Great. Thank you so much. First of all, thanks, everyone, for the time and interest. And we're a couple of weeks before Mother's Day. Lucy was a new mother last year. She missed this call. So hopefully, this year is a great year for you, Lucy. And to everybody out there, hopefully, they enjoy their family time and Mother's Day. And we'll speak to you in the summer.

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Bo Stanley, TPG Specialty Lending, Inc. - President [60]

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Thank you, everyone.

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Ian Simmonds, TPG Specialty Lending, Inc. - CFO [61]

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Thank you.

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Operator [62]

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