Good day, and thank you for standing by. Welcome to the Sixth Street Specialty Lending Q2 2022 earnings conference call. At this time, all participants are on a listen-only mode. After the speaker's presentation, there will be a question-and-answer session. To ask the question during the session, you will need to press star one one on your telephone. I would now like to hand the conference over to your speaker for today, Cami VanHorn. You may begin.
Thank you. Before we begin today's call, I would like to remind our listeners that remarks made during the call may contain forward-looking statements. Statements other than statements of historical facts made during this call may constitute forward-looking statements and are not guarantees of future performance or results and involve a number of risks and uncertainties. Actual results may differ materially from those in the forward-looking statements as a result of a number of factors, including those described from time to time in Sixth Street Specialty Lending, Inc.'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, we issued our earnings press release for the second quarter ended June 30th, 2022, and posted a presentation to the investor resources section of our website, www.sixthstreetspecialtylending.com.
The presentation should be reviewed in conjunction with our Form 10-Q filed yesterday with the SEC. Sixth Street Specialty Lending, Inc.'s earnings release is also available on our website under the Investor Resources section. Unless noted otherwise, all performance figures mentioned in today's prepared remarks are as of and for the second quarter ended June 30th, 2022. As a reminder, this call is being recorded for replay purposes. I will now turn the call over to Joshua Easterly, Chief Executive Officer of Sixth Street Specialty Lending, Inc.
Thank you, Cami. Good morning, everyone, and thank you for joining us. With us today is my partner and our President, Bo Stanley, and our CFO, Ian Simmonds. For our call today, I will provide highlights for this quarter's results and then pass over to Bo to discuss this quarter's origination activity and portfolio. Ian will review our quarterly financial results in more detail. I will conclude with final remarks before opening the call to Q&A. In addition to today's earnings call, earnings press release, investor presentation, and Form 10-Q, we also published a letter outlining a number of perspectives we felt would be valuable to our stakeholders. Consistent with our approach to provide additional communication during the first few months of the pandemic, we wanted to share our framework to continue the confidence our stakeholders have placed in the stewardship of their capital.
Given the outsized impact of the macroeconomic environment on markets and therefore our business, we thought it would be helpful to take the same approach with this quarter's earnings release. We encourage and welcome any feedback. After market closed yesterday, we reported second quarter financial results with adjusted net investment income per share of $0.42, corresponding to an annualized return on equity based on that adjusted net investment income of 9.9%. Inclusive of marks in the fair value of our investments, we also reported adjusted net loss per share of $0.30. Our adjusted net loss per share this quarter was driven overwhelmingly by unrealized losses as we incorporated the impact of wider market spreads on the valuation of our portfolio. Given its impact on our financial results, I'd like to spend a moment on the importance of our quarterly valuation framework.
As we said before, we believe that an intellectually honest framework for portfolio valuation is the bedrock for effective risk management. In determining fair value of assets at a moment in time, using inputs from the market is critical. As a result, we have incorporated the impact of market spread movements into the valuation of our portfolio, adjusting for the expected weighted average life and other idiosyncratic factors specific to each investment. One of our most important jobs is capital allocation. This cannot occur without marking our assets appropriately. We will continue to follow this framework as we have since inception, and we're confident it allows us to make sound investment and risk management decisions based on the market signals. We've laid out our framework more extensively in the letter I mentioned earlier.
Our investment income reflected a period where our results were driven by the core earnings power of our portfolio, with little contribution from activity levels driving other income. 93% of this quarter's total investment income was generated through interest and dividend income, compared to 85% across 2021 and 79% across 2020. The anticipated positive asset sensitivity of our portfolio, combined with more normalized activity levels driving other income, should further supplement our earnings results for the remainder of the year, providing support for an increase in our base dividend level, which I will discuss in a moment. Unrealized losses during the quarter resulted in a partial unwind of previously accrued capital gains incentive fees that we have discussed in prior quarters.
Given this unwind is tagged primarily to unrealized gains from our investments, consistent with how we've treated this line item in prior periods, we've adjusted this quarter's results to exclude the impact of this non-cash expense reversal, which was approximately $0.12 per share. Reported net investment income and net loss per share for Q2 were $0.54 and $0.18 respectively. Due to the strength of our historical credit performance in generating cumulative net realized gains in excess of unrealized losses, the remaining $0.09 per share of capital gains incentive fee on our balance sheet will continue to provide a cushion to any negative impact of market spread movements on net asset value. At quarter end, our net asset value per share declined by approximately 3.4% from $16.84, which includes the impact of the Q1 supplemental dividend to $16.27.
As discussed, the primary driver of this decline was $0.66 per share of unrealized losses from the impact of credit spread widening and lower implied equity values on the valuation of our portfolio. Note, this approach to incorporate credit spread movements within our valuation framework follows a fair value requirement for BDCs under the Investment Company Act of 1940 and is in accordance with it in GAAP. Ian will walk through the other drivers of this quarter's net asset value bridge in more detail. Turning now to a few thoughts on the current market environment. With the possibility of a recession on the horizon, we remain highly focused on our risk management framework to guide our investment and capital allocation decisions.
As we address those and other topics in our letter, we'll focus our time today on the impact of rising rates on our income statement. We expect to see meaningful positive asset sensitivity in the back half of the year. The combination of the rise in rates in Q2, we're now well above our average floor levels on our debt investments and the shape of the forward LIBOR or SOFR curve support that expectation. The rise in rates will drive incremental interest income and outweigh the increases in the cost of our liabilities. To date, this has been largely muted because applicable reference rate resets occurred earlier in the quarter.
Based on the shape of the forward curve and reset dates of our issuers, we project the remainder of this year that rate movement alone will result in approximately $0.13 per share of incremental net investment income purely from the core earnings power of the portfolio relative to what we experienced in Q2. In addition, to the extent we see portfolio growth over this period, the core earnings power of our business will be further enhanced. In previous periods of rising interest rates, for example, from 2017 to late 2018, the reality of asset sensitivity has been called into question given the tendency of the BDC sector to sacrifice spread in order to prioritize asset growth.
Given the spread environment today, our strong relative capital base and significant liquidity, we are well positioned to retain the asset sensitivity. Ian will provide an update on our full year guidance later on. While we view the rising rate environment in a positive light with respect to our earnings profile, we are cognizant of the impact more broadly on our borrowers of rising rates coupled with inflationary pressures on input prices and a more challenging operating environment. As Bo will discuss, despite these rising costs, the overall health of our borrowers' financial position remains strong. Based on our updated view of forward earnings yesterday, our board approved the third quarter base dividend of $0.42 per share to shareholders of record as of September 15th, payable on September 30th. This represents an increase of $0.01 per share to our quarterly base dividend.
There were no supplemental dividends declared related to Q2 earnings based on our formulaic supplemental dividend framework, largely due to lower activity-based fees during the quarter, as mentioned earlier. In a spread widening period where valuations experienced downward pressure, the NAV limiter in our framework also serves to retain capital and stabilize net asset value. We will note that following dialogue with and feedback from existing shareholder, our board approved a change to the payment date timing of our quarterly base dividends such that the record date and payment date will occur during the same fiscal quarter. This change has no material impact on our financial results but will accelerate the payment of the base dividend by approximately 15 days each quarter relative to our past practice. With that, I'll now pass it over to Bo to discuss this quarter's investment activity.
Thanks, Josh. I'd like to start by layering on some additional thoughts on the broader market backdrop and more specifically how it relates to the positioning of our portfolio and the way that we're thinking about the current opportunities in the market. Although we cannot predict the impact, timing, or severity of the Fed's actions on the economy, we feel confident that our portfolio is defensively positioned for a couple important reasons. First and foremost, we follow a differentiated approach to underwriting, which includes analyzing and understanding, among other things, the unit economics of our portfolio companies. We are heavily invested in businesses that are characterized by having predominantly variable cost structures, strong recurring revenue attributes, high switching costs, and low customer concentration.
We believe these fundamental characteristics will be key in the ongoing inflationary environment as we expect companies with pricing power and variable cost structures will be better positioned than those with large exposure to commodities, high fixed costs, and limited ability to pass through price increases. Secondly, we remain invested at the top of the capital structure with 90% of our portfolio by fair value in first lien loans. In this environment, with market expectations indicating that credit losses are likely to increase, we feel that our positioning at the top of the capital structure in defensive industries will serve to preserve our capital and support our robust return on equity profile. Our top two industry exposures are business services followed by financial services at 14.7% and 11.5% of the portfolio at fair value respectively.
Note that the vast majority of our exposure to financial services are B2B integrated software payment businesses with limited financial leverage and non-aligning bank regulatory risk. While we present our industry exposures based on the end market that our borrowers serve, from a broader lens, approximately 81% of our portfolio companies represent software and services-oriented businesses with high levels of recurring revenue and resilient business models. Retail ABL exposure remained relatively low at 5.9% of our portfolio on a fair value basis at quarter end. However, we expect the inflationary environment and high rate environment will likely create interesting opportunities for us to become more active in the space. Now I want to spend a moment on how we're viewing investment opportunities and portfolio activity against the current market backdrop.
During the quarter, high yield and broadly syndicated loan markets were mostly on the sidelines given the environment. Although liquid markets were quick to react, the private markets have been much slower to reprice and largely remain in a period of price discovery between buyers and sellers in terms of valuation. We anticipate there will be more opportunities to provide direct lending solutions as sponsors remain active in looking to deploy capital, as well as privately held companies looking to bolster their balance sheets. Our omni-channel approach to sourcing is critical in driving these opportunities. With the potential for increased deal flow in the second half of 2022, we continue to be very selective with our investment opportunities and have set a high bar for allocating our capital during this period.
As we said in the past, our primary priority is generating attractive risk-adjusted returns for our shareholders, which requires us to be disciplined in our approach to deploying capital. As it relates to the portfolio activity, we had $379 million of commitments and $325 million of fundings across eight new investments and upsizes to two existing portfolio companies during the quarter. Consistent with our focus on maintaining a defensive portfolio, our two largest investments, Crunchtime and Merative, were in software services companies with deeply embedded underlying products resulting in high-quality recurring revenue basis. Crunchtime was a first lien term loan where our relationship with the company from a previous successful investment that we exited in 2017 allowed us to act quickly to support the acquisition of Zenput, a highly complementary business to Crunchtime's enterprise management solutions.
As for our investment in Merative, formerly known as IBM Watson Healthcare business, we partnered with Francisco Partners to provide a funding for a complex transaction involving the carve-out of certain software assets. We leveraged the power of the Sixth Street platform as well as our deep relationship with the sponsor to provide a financing in the form of a senior secured credit facility to support the acquisition and carve-out with speed and certainty of execution. Both of these investments follow our thematic approach of underwriting the underlying sectors and industries that we believe are defensive and stable in the current environment.
Notably, although we only closed the Merative transaction at the end of June, pricing and terms of this transaction were agreed to back in February, and it was at that date that becomes a reference date for determining the impact of spread movements through the end of Q2. While there's been no deterioration in performance, that approach has resulted in an unrealized loss on the name alone for a fair value determination of approximately $0.02 per share in Q2. Other new investments during the quarter include several new deals and upsides to existing portfolio companies such as Staples, as well as an investment in an energy space, two merchants in oil and gas, which increased our energy exposure to 3.2% of our portfolio on a fair value basis as of the quarter end.
Similar to prior periods of market volatility, we made purchases of BB and BBB CLO liabilities, which comprise approximately $29 million of fundings during the quarter. As one of our core opportunistic investment themes, at certain moments in time, these investments present an efficient use of capital on their return profile. We purchased these securities at a significant discount to par with a yield to three-year recovery of approximately 12.5%, with significant subordination to protect against future credit losses. We believe our expertise in the structured credit market further highlights the benefit of the broader Sixth Street platform in terms of providing TSLX with differentiated deployment opportunities, especially in times of market dislocation. Moving on to the repayment side, there were $212 million of pay downs across six full and one partial investment realization.
Of the six full repayments, two were pay downs driven by refinancings which we participated in, thereby offsetting the pay down with subsequent new fundings during the quarter. Although the repayment activity in Q2 was in line with historical averages, the vast majority of our pay downs occurred during the first month of the quarter. As spreads widened more meaningfully in the back half of Q2, we saw a slowdown in repayments resulting in lower activity-based fees. For reference, 65% of repayment activity during the quarter occurred in April. Our largest payoff, Illuminate, occurred on April 1st and represented 30% of total repayment activity.
This investment generated 11.5% IRR and a 1.5x MOM during a hold period of 4.6 years, reflecting the older vintage nature of the payoffs in Q2, resulting in limited OIV in the quarter's net investment income. Supporting the performance of our portfolio this quarter was the announcement on May 10th of Pfizer acquiring all the outstanding shares of Biohaven. Our weighted average mark on Biohaven increased from 104% to 111% during the quarter, reflecting the impact of the anticipated fees embedded in our underlying exposure to the portfolio company. While incorporated in the Q2 fair value mark, the expected fees will eventually flow through investment income at the time of payoff, resulting in the crystallization of activity-related fees, increasing our capital base and creating incremental investment capacity for new deployment opportunities.
Our weighted average yield on debt and income-producing securities at amortized cost was up to 10.9% from 10.3% quarter-over-quarter and is up about 80 basis points from a year ago. The weighted average yield and amortized cost on new investments, including upsizes this quarter, was 10.1% compared to a yield of 9.5% on exited investments. Moving on to the portfolio composition and credit stats. Across our core borrowers for whom these metrics are relevant, we continue to have conservative weighted average attached and detached points on our loans of 0.8x and 4.6x respectively, and their weighted average interest coverage remained relatively stable at 2.6 x.
As of Q2 2022, the weighted average revenue and EBITDA of our core portfolio companies was $140 million and $34 million respectively. The performance rating on our portfolio continues to be strong, with a weighted average rating of 1.13 on a scale of 1 to 5, with 1 being the strongest, representing no change from the prior quarter. We continue to have minimal non-accruals at less than 0.01% of the portfolio at fair value, with no new names added to non-accrual during Q2. The stability of these metrics quarter-over-quarter illustrates there has been no deterioration in the underlying credit quality of our portfolio. While historical data is important, we recognize what really matters is future performance.
We believe we've done a good job positioning our portfolio to date, but as always, time will tell. Finally, the strong portfolio pipeline that we referenced during our last earnings call continues to provide us with attractive deployment opportunities. Given our strong liquidity and capital position, that has proved to be a competitive advantage relative to peers that operated with higher levels of financial leverage. We expect this aspect to extend in the current period of volatility as access to capital may become more constrained. With that, I'd like to turn it over to Ian to cover our financial performance in more detail.
Thank you, Bo. For Q2, we generated adjusted net investment income per share of $0.42 and adjusted net loss per share of $0.30. At quarter end, total investments were $2.5 billion, up slightly from the prior quarter as a result of net funding activity, partially offset by the impact of lower valuation marks on our portfolio. Total principal debt outstanding at quarter end was $1.3 billion, and net assets were $1.2 billion or $16.27 per share. Our average debt-to-equity ratio decreased slightly quarter-over-quarter from 0.95x to 0.9x, and our debt-to-equity ratio at June 30 was 1.06x, up from 0.91x at March 31.
The decrease in our average debt-to-equity ratio was driven by repayment activity in the beginning of the quarter, with leverage dropping to a low of 0.86x in April. As Bo mentioned, we saw a pause in repayments in the latter half of Q2 and increased fundings during the last few weeks of the quarter, resulting in a higher reported leverage metric at June 30. More specifically, net funding activity in isolation would have resulted in a leverage ratio of 1.02x at quarter end, with the delta to our reported quarter end figure of 1.06x being the impact of valuation marks on our investment portfolio. Before turning to our results, I would like to reiterate the strength of our liquidity, funding profile and capital position.
At quarter end, we had $1.2 billion of undrawn capacity on our revolving credit facility against only $155 million of unfunded portfolio company commitments available to be drawn based on contractual requirements in the underlying loan agreements. In addition to having significant liquidity, we remain well below the top end of our previously stated target leverage of 1.25 x, providing us with the ability to capitalize on attractive investment opportunities for our shareholders. We believe this combination of liquidity and our capital position, which proved its value and importance during the pandemic, positions us well across varying operating scenarios and enhances our competitive positioning. Our capital allocation framework remains top of mind for us as well, given current market dynamics, and we've elaborated on this subject in our letter.
As it relates to our debt maturity profile and any impact on liquidity, the remaining principal value of our convertible notes settled on Monday, August 1st, with no material impact on our liquidity. As mentioned in prior quarters, earlier this year, we elected to settle the converts primarily with stock, resulting in an equity issuance earlier this week of approximately 4.4 million shares. Close to 80% of the outstanding principal amount was settled in stock, and the corresponding equity issuance translated to approximately $0.08 per share of accretion to our net asset value, which will be reflected in our Q3 financial results. This transaction improved our capital positioning by lowering our leverage ratio and increasing our capital base, thereby creating additional capacity to invest in interesting new opportunities as they arise.
Quarter to date, our net funding of new investments amounts to approximately $145 million. Pro forma for the settlement of these convertible notes early this week, and inclusive of the impact of net fundings and broad market credit spread tightening of approximately 50 basis points since quarter end, we estimate our current leverage is 1.04 x, with liquidity of approximately $1 billion. After the settlement of these convertible notes, our funding mix is comprised of 57% unsecured debt and 43% secured debt. Moving to our presentation materials. Slide eight contains this quarter's NAV bridge. As Josh mentioned, the impact of credit spread widening on the valuation of our portfolio was by far the most significant driver of NAV movement this quarter, with unrealized losses of $0.66 per share.
Again, absent permanent credit losses, we would expect to see a reversal of these unrealized losses related to credit spreads over time, as our investments approach their respective maturities. The estimated impact of broad market credit spread tightening since quarter end that I referenced earlier, represents approximately $0.16 per share unwind of the unrealized losses we saw during Q2. Walking through the other drivers of NAV movement this quarter, we added $0.42 per share from net investment income against a base dividend of $0.41 per share. There was a $0.12 per share uplift to NAV related to the unwind of previously accrued capital gains incentive fees, which Josh also mentioned earlier. Finally, there was a $0.04 per share decline in NAV from the unwind of unrealized gains as a result of pay downs. Moving on to our operating results detail on slide nine.
Total investment income for the quarter was $63.9 million, compared to $67.4 million in the prior quarter. Walking through the components of income, interest and dividend income was $59.1 million, up slightly from the prior quarter, driven by net funding activity during Q2. Other fees, representing prepayment fees and accelerated amortization of upfront fees from unscheduled pay downs were lower at $3.2 million compared to $6.9 million in Q1, given the lower impact on income measures from repayment activity that we highlighted earlier. Other income was $1.6 million compared to $1.8 million in the prior quarter. Net expenses, excluding the impact of non-cash accrual related to capital gains incentive fees, were $31.4 million, up approximately 5% from prior quarter.
The increase in net expenses quarter-over-quarter was primarily driven by the upward movement in reference rates, which increased our weighted average interest rate on average debt outstanding from 2.3% to 3.1%. There is a lag to the impact of rising interest rates on the weighted average interest rate on average debt outstanding, and the increase this quarter is largely explained by the movement in base rates from the prior quarter. Before I discuss our guidance for the remainder of the year, noting for those that track this metric, as of the end of the quarter, we estimate that our spillover income per share is approximately $0.56. Year to date through June 30, we have generated adjusted net investment income per share of $0.90, corresponding to an annualized return on equity of 11%.
This compares to the target return on equity that we have articulated throughout 2022 of 11%-11.5% or $1.84-$1.92 on a per share basis. Based on the impact of the positive asset sensitivity in our business that Josh referred to earlier, resulting in higher anticipated net investment income, combined with the strong overall health of our portfolio, we expect to exceed the top end of our target range for full year 2022. With that, I'd like to turn it back to Josh for concluding remarks.
Thanks, Ian. We hope people take the time to read our letter as we outline what we really think matters in driving shareholder returns. Brevity isn't one of our strengths. We apologize in advance. With a clear understanding of what is important in driving the results of our business, we will continue to create value for our stakeholders and serve our portfolio companies, management teams, and financial sponsor partners with creative financing solutions. In closing, I want to wish everyone a wonderful rest of the summer with their friends and loved ones. With that, thank you for your time today. Operator, please open up the line for questions.
Thank you. As a reminder to ask the question, you will need to press star one one on your telephone. Please stand by while we compile the Q&A roster. Once again, that's star one one to ask a question. One moment for our first question. Our first question comes from the line of Finian O'Shea with [audio distortion]. Your line is open.
Hi, good morning. Thank you. Can you tell us about the new BDC Sixth Street has on file? Would it fall within the same origination line as Sixth Street has on file? Would it fall within the same origination line as TSLX and or otherwise, how would the investment style compare?
Hey, good morning, Finn. How are you? Look, we're obviously limited on what we could talk about given the private placement rules. What I would say is, it's a completely different investment strategy than Sixth Street Specialty Lending. There should be limited overlap. As you know, for the last 10 years, I guess 12 years since we formed Sixth Street Specialty Lending, our sole focus and our continued focus will be on creating shareholder returns. Obviously, the direct lending market has opened up significantly. There are areas in that market, given TSLX's capital base and our, you know, unwillingness to raise equity all the time that you know, we can't be involved in. Given the private placement rules, it's hard to talk about at this moment. I assure you that it will have no impact on Sixth Street Specialty Lending's focus, or cannibalize its opportunity set in any way.
Okay. Helpful. Thank you. As a follow-up, one of your BDC peers yesterday lowered its base fee to accrue on NAV, essentially, instead of assets this week, seeing if you have any sort of initial thoughts on that, what it might mean for the industry, how you think about it.
Look, I could say a lot of snarky things, and I'll try not to say snarky things. One is, I think that peer had a long history of problems on the performance side and also changed investment strategy over time. I think when you look at the yield on their investments and you think about just the simple portfolio yield minus the fee, I think their debt investment portfolio is like a 7.7 yield. Their effective fee now, given NAV, is like 70 basis points. Their net yield prior to leverage and prior to incentive fees is like 7%, right? Other costs. When you look at the TSLX portfolio, I think our yield and amortized cost [guess] is-
10.9.
10.9. Doing the same math, adjusted for 1.5%, that gets you to.
94.
9.4. We're still 240 basis points higher prior to accounting for [guess] related to credit loss, and quite frankly, we're generating, you know, return on equity, I think pro forma significantly higher and using less financial leverage to do so. Look, they have had a change of strategy over time. They've put a whole bunch of spread compression in their book, and they had performance issues on the credit side, so it's not shocking, but it might be appropriate for that strategy. Then the last thing I'll say, I was a little confused about the purchase at NAV, given that the stock price is way below NAV. As I understand, the affiliate is owned by other people too. That was a little confusing, but I'm sure there was reason to do that.
Very well. Thanks so much.
Thank you. Please stand by for our next question. Our next question comes from the line of Mickey Schleien with Ladenburg. Your line is open.
Good morning, everyone. Josh, in the prepared remarks, I think I understood that you said, your fee income or you expect your fee income to be, to improve in the second half of the year. Could you just help us reconcile that against a rising rate environment? Because typically we would expect rising rates to limit prepayments. As a follow-up to the question, why was fee income a little light this quarter, relative to you know, historical levels?
Yeah. First of all, I think we don't run a mortgage book, so I think that's true in mortgage land. I think it's spreads that matter. Your point is taken. If you think about widening spreads, we don't have a rate-sensitive book compared to prepayments. We have a spread-sensitive book compared to prepayments. Obviously spreads wore out. Borrowers have access to, you know, they have spreads that they don't wanna opportunistically refi. Valuations for private sellers and buyers and sellers of private businesses that it needs time to figure out a new valuation. I would say two things on the forward. One is, even though spreads are widening, we expect M&A to increase over time.
Some of our portfolio will ultimately churn, but there's this period in the private markets where that doesn't happen given the valuation disconnect. The other item, which I think is clear and has been announced, is that Biohaven, and you know, I'm not part of that management team and part of the acquirer, which I think is Pfizer. I don't want to speak to the timing of that, but that's a change of control transaction, and there's significant call protection in that. That will be rolling through. I don't know if it's Q4 or whatever back half, but it's going to be most definitely rolling through. I think the combination of that, we expect M&A markets to thaw. They didn't thaw in Q2.
As M&A markets thaw and certain buyers and sellers see eye to eye, their portfolio churn will increase a little bit. Then we can look in our book and look at the idiosyncratic things such as Biohaven that we have visibility into.
Appreciate that. I understand. Josh, one last question. If we look at the leveraged loan market sort of as an indicator of where, you know, defaults might go, the distressed ratio is a little north of 3%. You know, looking at your crystal ball out for the rest of this year and going into next year, do you expect defaults to climb to those levels? How do you expect your portfolio to behave in terms of credit given the trends that we're seeing in the economy?
Yeah. Mickey, you hit it head on, which is, I think if people read our letter, what we've said is there is no free ride, broad-based free ride. We think our portfolio behaves differently on rising rates. Rising rates will lead to a default cycle, especially if you believe we're in some stagflationary environment where there's inflation but very low growth. If you look at credit spreads as a proxy, credit spreads are telling you that the return needed to extend credit should be higher given prospective defaults and losses. I think, you know, I don't have a crystal ball on what that number is.
You know, there's a whole bunch of ways to do the math and, you know, if you think that historically, you know, the average single B has had a net spread post losses of 200-250 basis points, you can look at the price losses going forward, given spreads. There's a whole bunch of ways to do the math. Directionally, I think most definitely defaults and losses are gonna increase, and investors in the space, in the B, C space can only net investment income, less realized losses. I think that's really important. The second thing is our portfolio is really defensive.
Top of the capital structure, I think 80% was in the prepared marks of basically business service and software, where there's recurring revenue and variable cost structure and really no inputs that are linked to inflation. I think we feel really good and quite frankly, pricing power. I think we feel really good about where our portfolio is headed. In addition to all those things and attributes, why they have those attributes like pricing power is because they're solving problems for our portfolio companies are solving problems for their customers that are real and valuable to them. If you look at our portfolio, I think year-over-year portfolio growth was about 31%. Quarter-over-quarter was about 7.2, so 28% annualized.
You're still strong portfolio growth, still revenue growth in our portfolio companies and our core portfolio companies, although it is clearly decelerating, but our portfolio companies have much more levers on the cost side, given their variable cost nature. I feel pretty good about our portfolio. I feel pretty good about the forward earnings power of our business, given the inflection on rising rates, and I'm positive, and quite frankly, we have a whole bunch of embedded earnings power in our business, given that we have more capital, more liquidity in the space to take advantage of a, you know, a better lending environment. I'm excited.
I appreciate that, Josh. Thanks for all the transparency. We certainly appreciate it very much. That's it for me this morning.
Thanks, Mickey.
Thank you. Please stand by for our next question. Our next question comes from the line of Kevin Fultz with JMP Securities. Your line is open.
Hi, good morning, and thank you for taking my questions. You know, you touched on this a bit in Mickey's question. Clearly, portfolio credit quality is in excellent shape with non-accruals at cost of 0.1%. Just curious from where you sit, Josh, and how you think about things. Are there certain verticals that you see as more at risk in the current environment, whether that's due to inflation, labor issues, geopolitical risk or recession fears that you are monitoring more closely as the macro environment continues to evolve?
Yeah. It's a great question. Yeah, I mean, we're very positive on our portfolio. Look, we've been thoughtful about how we've built that portfolio and the characteristics of those companies and where we invest in the capital structure. If you take a giant step back and look at what's happening in the world today, the policymakers have to get inflation under control. The only way to get inflation under control is effectively to kill the consumer, unfortunately. Part of killing a consumer, you know, is a restrictive monetary policy, which takes dollars out of their pocket, and also increasing the cost of capital to companies for them to make investment decisions and hiring decisions, et cetera.
You can expect that unemployment is going to rise. The consumer is going to get in worse shape. I think I saw a headline yesterday where consumer debt's up and credit card debt's up, et cetera. I think we're in a really tricky environment. The question is, can the Fed get to a soft landing where they can kill the consumer enough, to land the plane on the proverbial head of a needle, but not kill the economy? You know, I think the market is, you know, kind of trying to figure that out. Our portfolio generally is a B2B portfolio. We don't have a whole bunch of consumer, you know, we don't have any retail outside of ABL.
We don't have the cost structure of our business don't have a whole bunch of commodity inputs that had inflation where they can't price on. They can't and that we don't have those, that nature of that portfolio company where there's commodities in the cost structure. I would be aware of low margin businesses that have measured by EBITDA margins or EBIT margins that have commodity inputs or those businesses that are affected by inflation, where they probably don't have pricing power. In those businesses that have or around consumers, I think are gonna be challenged going forward too as well. I feel relatively good about, again, the portfolio positioning. Look, our world and the economy is very interconnected. I tried to talk about this in our letter. You know, B2B is gonna be affected too. Most definitely, I think we have a more insulated defensive portfolio.
Okay. That's all really helpful, Josh, and thank you for taking my questions. I'll leave it there.
Thank you. Please stand by for our next question. Our next question comes from the line of Kenneth Lee with RBC Capital Markets. Your line is open.
Hey, good morning, and thanks for taking my question. Just one on the CLO investments you mentioned. You talked about it being an efficient use of capital. Just wondering whether you could just further flesh out, you know, how these investments compare with your more traditional debt investments. As well, how do you think about the risks, especially under potential macro deterioration, compared with most of your other debt investments? Thanks.
Yeah. Yeah. It's a great question. First of all, we've had this strategy in place over time. I think we invested in a bunch in 2015-2016. We did it in COVID. I think we might have done it in 2018-2019 when there was a market blip, where there's a lot of forced selling coming out of those markets because they're held by mutual funds. People have to be forced sellers. When you look at the loss taking ability in those securities, you have to think that broadly syndicated loan default rates are very, very high and stay high for a long time. You have less idiosyncratic kind of insight, although we go portfolio by portfolio and look at the underlying names.
Although the underlying names can change it during their reinvestment period. Historically, when you look at, so they have greater loss taking ability, around defaults, although not on an idiosyncratic basis. And when you look at the private loans, usually had offered about a 400 basis point premium to BB. When you look at the environment that we've been in, that environment is now the spread premium was flat to negative 300 basis points. The relative value was really, really wide, and the yield to recoveries were in the kinda low teens. We just think it's a much more efficient use of our capital.
Quite frankly, it's also a source of liquidity, unlike private loans, which can never be a source of liquidity. You know, we like that. We've done it. We have a team that is focused on it, and we think we have unique insights. You know, again, we're focused on efficiently using our shareholders' capital to create total returns, both on a spread basis and on a capital appreciation basis. You know, you can buy triple-B security at 90 or 89 with a lot of loss taking ability, where the world would have to end if it was ever in default.
I think what historical defaults have been or losses have been zero in BBB , again, with 10 points over LQD, and with as good a risk, as good a spread, it just seems like a no-brainer.
Gotcha. Very helpful there. One follow-up, if I may, just on the valuation changes. It sounds like from the prepared remarks, a lot of it was mainly spread driven. Wondering, you know, how much did the idiosyncratic factors drive some of the fair value changes within the portfolio? Thanks.
Yeah. I would group them in really two categories. The two categories being broad-based spread movements. Then, as you know, we have a small equity book and equity premiums, risk premiums widen as well. There wasn't really any performance-based markdowns broadly in the book. The book is performing. It's a combination of on the equity instruments we hold, valuations came down. Now in kinda if you think about corporate finance, they should earn, they should generate a return, you know, from a go-forward basis from the trough valuations. It's less visible because equities have longer duration and don't have a maturity.
The other bucket is the credit spread, which is quite frankly, if we're right on credit, all the unrealized losses that went to the book should actually unwind, because at some point we will get our par back at maturity or before maturity, so those should all unwind. There was not really any broad-based performance markdowns in the book. It was a combination of spreads widening and on our equity book, equity valuations came down.
Gotcha. Very helpful there. Thanks again.
Thank you. Please stand by for our next question. Our next question comes from the line of Robert Dodd with Raymond James. Your line is open.
Hi. Good morning. Thanks for all the color on the NAV and the letter. I did read that. It's quite interesting. Not on that topic. When you look at, you know, historically you have generated a lot of income from fee structures, a lot of core protection in the way you structure loans, et cetera. You know, maybe not in this environment, but, you know, over the next couple of years, do you expect any pushback from borrowers on the amount of kind of call protection you embed given how competitive the private credit market is increasingly getting? Was it a case of, frankly, the borrower doesn't care that much because the call protection is usually paid by an acquirer in an M&A event?
Cool. I'm not sure the call protection is made by acquiring an M&A event. It comes out of the seller proceeds. Put that in, you know. That's the seller's capital structure. They bear the cost of the capital structure. I would say, first of all, I think the premise of that, the competitive environment, I think is changing significantly or on the margin significantly more than we've seen historically, which is, I don't know if it's lack of retail flows in the products or people being at the top end of their leverage, and so there's less capital. We have seen spreads increase.
You know, we saw at the end of the quarter, that's why we reflected in our book, along with broadly syndicated loans. We're seeing it now. We're seeing reinvestment spreads increase. We're seeing fees go up, and we're seeing leverage go down. The world is becoming a better, you know, kind of a better place for lenders. My guess is it's also becoming a better place for buyers on the private equity side because they're buying at lower valuations. I think generally terms are being more lender-friendly and buyers are getting better terms given the change in the valuation environment.
The one thing I would say is when you look at kind of as a proxy for how much, say, how much NAV increase is embedded in our book, the metric that we post that you should look at is fair value of the portfolio related to call protection.
Mm-hmm.
Because that tells you if the book liquidates today, how much is rolling through either the unrealized realized gain section and how much and some of that will roll through the investment income line. This quarter, I think is, you know, and part of this is because the markdown, it was 94.1. So last quarter was 95.1. When you look at our book as it relates to where people are carrying it as a percentage of call price, it's the cheapest it's been at least in the last five quarters I've been looking at it.
Got it. I do look at that line. I mean, what obviously, that to a degree, the core protection goes, well, not to a degree. I mean, it goes down over time as assets age.
Yeah.
In many cases. I mean, you know, have you changed anything on your probability weighting call protection, et cetera, when you're coming up with fair values, et cetera. Has anything been changed on that piece of the framework?
Most definitely. Sorry, when we come up with fair value. Sorry. I think your question was that have we changed, when you look at our fair value of investments, effectively, has the weighted average life of our book increased a little bit, and therefore, the probability of call protection has decreased because call protection is a melting ice cube. I think that was your question. Just, I wanna make sure I get your question.
Yep.
I think the answer is yes, on the margin. Given the wider spread environment, you know, the weighted average life has most definitely increased a little bit.
Got it. Thank you.
Thank you. Please stand by for our next question. Our next question comes from the line of Melissa Wedel with JPMorgan. Your line is open.
Good morning, and thanks for taking my questions. I'll reiterate prior comments about just appreciating the shareholder letter that you guys posted with a lot of detail about how you're thinking about the environment. I wanted to follow up on a comment you made earlier about sort of expecting an elevated pipeline perhaps in the second half. I wanted to touch on that a little bit more. Do you think it would be fair to say that, you know, given the rate environment, a lot of companies wouldn't necessarily wanna be in the market in the second half unless they had to? Perhaps the pipeline might be a little bit more stressed than what we've seen in the first half. If so, you know, how you're mitigating that.
Yeah. Look, what I think is really interesting because Bo should comment on this. There's a ton of private equity dry powder. There are buyers that are willing to transact, and we're seeing that. If you look at first quarter net fundings was $150 million. Whatever excess cash, Ian, correct me if I'm right. For the first quarter, this Q3's quarter to date.
Quarter to date. Yeah.
Net funding.
July, basically.
July was $150 million. So that tells you about the demand for credit on the M&A side. That historically relates to net fundings on average between, you know, $50 million and $75 million, I think. On the net fundings, we're already up $150 million July to date. We've already used. Effectively, we used. If we ended the quarter at 1x approximately debt to equity. We're 1x debt to equity after the converts. So we've used capital. When you look at, I don't think there's. We've been. I think we're probably busier now than we were in the last 12 months.
You're having a combination of there is a whole bunch of private equity dry powder in the system, and you've now had time where buyers and sellers start seeing eye to eye on valuation, where sellers don't say to themselves, "Oh, you know, in their mind, 'I'm gonna buy the dip. Things are going to change.'" They've now started to capitulate a little bit. Public companies are capitulating on take privates, and there's capital out there on the private equity side. Lending terms are getting better, and valuation terms for the buyers are getting better. It kinda all works. I'm pretty bullish about the opportunity set going forward. We're positioned at the low end of our target debt to equity, and we're positioned at the low end of the space.
We have more capital, more liquidity than the rest of the space. I mean, you know, I think one competitor who, you know, was at 1.5x debt to equity, who cut their fees, who have a different strategy. I think Ares, you know, was at 1-6. We have relatively more capital, more liquidity for our balance sheet than the space. I'm jazzed about the forward with wider spreads and a higher base rate environment and a high quality portfolio. Bo, I don't know if anything to add. I think I took all your thunder.
You took all of it. The only thing I would add is that, look, we'll see a lot of opportunistic M&A, and we're seeing that. The pipeline is as busy as it has been in quite some time with opportunistic M&A, both from a private equity world that are seeing values that have come down and also from the corporate world where, you know, the best businesses are actually bolstering their balance sheets to be on the offensive. Then lastly, you know, equity markets have been very cheap over the last three to five years. You know, good businesses are now turning to the credit markets to bolster their balance sheets versus raising very cheap equity. That combination has us quite bullish on the opportunity set in the second half of the year, combined with a much more favorable lending environment where we're seeing leverage come in, pricing and fees go up.
Yeah, Bo hit it. Let me add on. He actually hit it better than I did.
All very helpful. I appreciate that. Then to follow up on it, given the bullishness of the team, you know, and the capacity that you have from a leverage standpoint, just wanna clarify, like, where you would be comfortable taking leverage, portfolio leverage up to sort of the higher end of that target range, into this environment, given you know, sort of greater macro risk. Also wanna clarify, one, is that the case? Two, how are you thinking about leverage? Is that, you know, sort of on balance sheet, or is that also inclusive of the undrawn commitments, which you also touched on in that shareholder letter? Thank you.
Yeah. It's a really great question, complicated question. What I would tell you is I don't think we're never gonna take it up to 1.5x. The way we think about our balance sheet is we reserve for unfunded commitments. This is on the capital side. Some of this is applicable to the liquidity side too. Reserve for unfunded commitments because that reduces our capital when those get funded. It increases our leverage. We reserve for a, you know, credit spread widening because that reduces our capital on a mark-to-market basis. We would like to have dry powder to make investments in our capital structure and make new investments.
You know, if that's 1.15-1.2, it's kind of in that range. But it's a moving target because it's a function of unfunded commitments that we have as well, given that we have to burden our capital and burden the liquidity for that. If you look at our business and you take a step back and you say, "What is the constraint in our business? Is it capital or is it liquidity?" The constraint is capital. Well, not capital constraint, so don't read it that way. Like, if we have more liquidity given our financial policies, then we do capital on the margin. It's kind of in that range.
It's a moving target. Times like today, we run balance sheets daily or weekly and overlay our forward pipeline. You know, we're pretty thoughtful about how we put our capital to work, and understanding our own cost of capital because I think that's the path to shareholder value creation.
Got it. Thank you, Josh.
Thank you. Please stand by for our next question. Our next question comes from the line of Ryan Lynch with KBW. Your line is open.
Hey, good morning. First question I had was, you mentioned the investments you made in some CLOs in the quarter. Kind of a two-parter on that. One, is that opportunity set still exist in the marketplace today? And then also it sounds like you're seeing a ton of opportunities just in the private markets, but are there with the dislocations we've seen in kind of the liquid markets, which obviously contribute to the opportunities in the CLO markets. Are you seeing any direct opportunities to invest in any secondary positions, whether that's any sort of leveraged loans or high-yield bonds in this marketplace, or is it just limited right now to CLOs?
I think the 6.30 was kind of the low point on CLOs. I think we were flat basically on those purchases during the quarter, and then things have come up on prices 2-3 points or something like that. We haven't made any additional purchases. As it relates to, you know, secondary purchases of names, we're most definitely looking. I don't think they offer a strong relative value as the CLOs do. You know, again, this is not CLO equity. This is not like first loss in the capital structure. This is where there's protection against losses in the structure.
On the margin, all things being equal, when you think about kinda how we would like to use our capital, we like to use our capital to support our clients if it makes sense on a relative value basis. Like when I think about the pecking order, I actually think about, you know, if we're getting paid enough, I'd rather do it in private loans because that's our business and I like to support our clients. You know, if we're gonna do liquid stuff, you know, I start looking at relative value. Again, the relative value seemed like a no-brainer, and in that at that moment of time, you know, we've done this over history and we've done a pretty good job of it.
On the margin, I'd rather use our capital to support our clients. We have most definitely looked at broadly syndicated loans and, you know, high yield is tougher for us just because, you know, you're making an implicit rate bet and they're longer duration. The thing we generally like about private credit, the last thing I'll say is that does have a shorter weighted average life. Your spread for weighted average life, if you think about that metric is, you know, very attractive versus high yield, your discount margin and weighted average life is, you know, less attractive. Broadly syndicated loans as well. They're kind of set up so they don't have to talk to their lenders.
Okay, understood. The other one that I had was you mentioned a lot about your portfolio companies having variable cost structures. Can you explain, you know, what that is exactly? I'm not sure if you're referring to maybe your software businesses. I would assume if that's the case, maybe it's more like sales and marketing. They can toggle on and off, but I'm just curious, what is the variable nature of these cost structures that they can kind of toggle?
Bingo. Yeah, you hit it.
Okay.
Yeah.
Okay. And then just one clarification just for me, just to make sure the commentary you gave with the $0.13 of additional earnings in the second half of 2022, given the shape of the curve and where LIBOR is today and kind of the curve of LIBOR so far. I just wanna be clear, that is the cumulative amount that you guys would expect over the second half of 2022. I would assume that would build throughout the last two quarters. $0.13 in total, you know, just a rough estimate. You could say like, you know, $0.05 in Q3 and $0.08 or something.
$0.05 and $0.08.
Q4, something like. Okay.
Yes. You're spot on, Ryan. $0.05 and $0.08. Ryan, the way to think about it is the effective LIBOR in our book this past quarter, weighted average effective LIBOR was like 107. We had very little asset sensitivity in our book, which was right above our floors. I think on a bottoms-up basis, people can correct me if I'm wrong, we went reset by reset. On a bottoms-up basis, we're at like 190 in Q1 90. Well, at the if everybody reset at the end of Q2, we would be at 190. Then it goes up from there. We kinda looked at it as on, and that's kinda footnote asset sensitivity table in the Q.
You have to adjust for the incentive fee because that's just on a net investment income less interest cost basis, so you have to adjust for the incentive fee. It is, you know, the book is about giving the resets, and we're through the floors. The book is about to take off.
Yep. Okay. That makes sense. I appreciate you taking my questions and really appreciate the good detail you gave in your shareholder letter.
Thank you.
Thanks, Ryan.
I'm showing no further questions in the queue. I would now like to turn the call back over to Joshua Easterly for closing remarks.
Great. Thank you so much. Thank you for the questions. Thank you for the time for reading a 10-page letter or a 12-page. Hopefully you didn't read the disclosures. Those are important as our lawyers would remind me. We really appreciate it. I hope everybody has a great rest of the summer and a Labor Day with their family. We're around in the fall. As I keep saying, we're back in the office full time, so please feel free to come visit, and we look at getting back on the road. I think the nice things of where we are, hopefully with a little bit post-pandemic as we're getting out and seeing shareholders and other stakeholders and portfolio companies and sponsors. We're back out on the road and welcome people in our office. Thank you so much.
Thank you.
Thanks, everybody.
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