TSLX - Sixth Street Specialty Lending: Q3 Update - Another Solid Result

2023-12-20 00:16:34 ET

Summary

• Sixth Street Specialty Lending reported strong Q3 results with a 4.6% total NAV return and a modest rise in net income.
• TSLX's portfolio is well-diversified, focusing on the Tech, Healthcare, and Human Resources sectors.
• The company's high and rising interest expenses have been key headwinds for its net income.

In this article, we discuss the latest quarterly results from the Business Development Company Sixth Street Specialty Lending ( TSLX ). The company's portfolio is well-diversified and focused on the typical Tech and Healthcare sectors alongside Human Resources which is a bit unusual for BDCs.

Quarter Update

Adjusted net investment income rose to $0.60 - an increase of a penny from the previous quarter. This was still below the last Q4 figure when net income reached a peak, however, recall that the company had a non-recurring income of $0.12 in that quarter.

This net income increase was below that of the average BDC due to the fact that TSLX relies entirely on floating-rate liabilities (by hedging out those which are fixed-rate) which means that its level of interest expense has grown at a much quicker pace (if not the quickest) relative to the sector. An average BDC has only half of its liabilities in floating-rate format.

TSLX is likely to see a bumper Q4 given the seasonality of its fee income shown below. Typically, many private equity deals get pushed across the line at the end of the year which tends to lead to sizable prepayment income. This was the case even in 2022 which had much worse deal risk sentiment than today.

Regular dividend coverage remains very high at 130% and total dividend coverage (Q4 regular of $0.46 and Q3 supplemental of $0.07) was a healthy 113%.

The NAV finished 1.4% above its Q3 level as a result of retained income as well as unrealized (the largest item) and realized gains. Unrealized gains are something we have seen nearly across the board in the sector over Q3.

This was the fifth straight quarter of NAV gains.

As a result, the NAV is not far off its peak.

Income Dynamics

Net new investments were roughly flat over the quarter.

As a result of this as well as higher NAV, leverage ticked lower.

Asset yield increased to 14.2% while interest expense rose faster to 7.5%. TSLX has a very high cost of debt relative to other higher-quality BDCs (e.g. ARCC and BXSL both below 5%) because it swaps all of its debt to floating rates. This has obviously been a drag on its net income over the last while.

If there is a silver lining is that this disadvantage will diminish over the coming years if rates stay elevated as the bonds of other BDCs mature and are refinanced at higher coupons. The company's high level of asset yield also means it boasts a slightly above-average level of yield differential.

The company issued a new $300m 5Y bond at SOFR + 2.99% in order to refinance its 2024 bond. Unfortunately, the new bond was issued at a spread close to 0.5% above the 2024 bond which will increase interest expense further, all else equal.

Portfolio Quality

Non-accruals remained at a very low level - less than half the median value on a fair-value basis. No new portfolio companies were added to non-accrual status from the prior quarter.

TSLX continued its very strong track record of net realized gains for the 8th quarter in a row.

PIK was well-behaved and below the sector average.

Weighted-average interest coverage fell from 2.1x to 2x, driven by the impact of higher short-term rates. Around 5% of the portfolio outside of the non-accrual had interest coverage below 1x.

Return And Valuation Profile

TSLX has tended to trade at a premium valuation relative to the broader sector. This makes sense in the context of its very strong performance - it remains one of the best performers in the sector.

The current premium of 23% to the sector average valuation is not excessive as it has tended to trade north of 20% outside of a couple of risk-off periods.

On a 5Y total NAV return basis, it is only behind HTGC in our coverage. In this sense, it is a superior alternative to MAIN or CSWC given its much lower valuation and stronger performance.

Performance has also been very consistent - it has only underperformed the sector in two of the last 20 quarters.

Despite its premium level, the valuation is fairly reasonable. 5Y total NAV returns per unit of valuation is one of the highest in our coverage.

Stance and Takeaways

TSLX remains one of the strongest and most consistent performers in the sector while trading at a valuation that is well below several other strong BDCs. Coverage is high which leaves room for additional net income gains, particularly as fee-sourced income is at a rock bottom level. The portfolio is focused on first-lien loans and the quality of the holdings has been resilient.

After adding the stock in mid-March at a very attractive sub-105% valuation (about 14% above the sector average at the time as shown in the chart below), we exited the position after it hit a valuation level of 125% (about 21% above the sector average valuation).

The current relative valuation is not particularly expensive nor is it cheap. The stock's relative valuation has been highly procyclical (i.e. richening vs. the sector in a risk-on environment and vice-versa). For this reason, we wouldn't be surprised to see it deflate significantly during the next bump in markets.

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