2023-03-12 09:15:00 ET
Summary
- Sixth Street Specialty Lending has an excellent track record of producing strong shareholder returns.
- It carries a reasonably strong balance sheet and pays a well-covered regular dividend supplemented by special dividends.
- The recent drop in price presents a solid opportunity for income investors to layer into this high yield.
The implosion of Silicon Valley Bank ( SIVB ) has put the greater financial sector on notice, including BDCs.
However, not all financial companies are the same. For one thing, BDCs have a permanent equity capital base rather than a customer deposit base that can be redeemed at a moment’s notice.
But as always, the market tends to react in tandem, and as shown below, Sixth Street Specialty Lending ( TSLX ) is now back to the low end of its trading range over the past 12 months, pushing its yield to 10.5%.
Let’s explore what makes now a potentially great time to add to this high yielding name.
Why TSLX?
Sixth Street Specialty Lending is an externally-managed BDC that invests in the U.S. middle market space, primarily through senior secured loans and equity investments in portfolio companies. It targets portfolio companies with $10 to $250 million in annual EBITDA.
TSLX has a strong track record of shareholder returns, which equates to a more than doubling of investor capital since IPO. This is reflected by the $36.99 in NAV per share plus cumulative and special dividends since IPO in 2011, with an initial price of $14.71.
TSLX maintains a well-diversified portfolio in mostly defensive industries, including business services, consumer products, internet services, and financial services, which represent its top industries. At present, it has investments in 78 portfolio companies with the largest investment representing just 2.8% of total value.
Management maintains prudent lending practices, as it has 92% voting control on debt investments and 90% of investments are in the form of first-lien secured debt, which means that TSLX would be the first in line to collect back its principal in the event of a borrower default. This also does not appear to be a risk at present, as investments on non-accrual status represent just 0.01% of portfolio fair value.
Moreover, TSLX is benefiting from rising rates as 99% of its debt investments are floating rate. As shown below, TSLX’s weighted average yield on debt rose materially by 320 basis points over the past year to 13.4% as of the end of 2022.
Management also seeks to reduce duration risk as it matches its own debt funding (100% floating rate) with that of its investments. This helps to avoid duration risk situation, in which long-term interest rates on investments fall below that of short-term rates.
Plus, TSLX maintains a responsible amount of leverage with a debt to equity ratio of 1.13x, sitting well below the 2.0x regulatory limit. It also has plenty of liquidity with $866 million of undrawn capacity on its revolving credit facility against just $178 million of unfunded portfolio commitments. As shown below, this also compares favorably to its near-term debt maturities.
Looking ahead, it doesn’t appear that TSLX needs further rate hikes as it’s already generating a healthy portfolio yield, and future hikes may dampen the economy. The potential silver lining is that the Fed may be getting the message with the implosion of Silicon Valley Bank and a “cooperative” jobs report , as the market is now pricing in a quarter point rate hike instead of a half point hike at the next Fed meeting.
Management highlight the strength of its portfolio in face of economic uncertainty due to rate hikes, as noted during the recent conference call :
A broad-based slowdown in the economy, coupled with the current rate environment, will cause some stress for borrowers.
This highlights the importance of why we are focused on business models with high variable cost structures and with those that have pricing power. 82% of our portfolio by fair value was comprised of software and business services companies at quarter end and are generally characterized by high levels of recurring revenue, predictable cash flows, variable cost structures and pricing power.
Our portfolio has shown resiliency to date, and we believe the underlying business models of our bars are robust and durable. However, we believe economic cycles do exist. As such, we will continue to focus on staying on top of the capital structure and operate in the middle of our target leverage range.
Meanwhile, TSLX currently yields a strong 10.5% and the dividend is well-covered by a 71% payout ratio, based on Q4 NII/share of $0.65. This enabled TSLX to pay a $0.09 special dividend this quarter.
Lastly, TSLX is attractive after the recent material drop in price to $17.55, equating to a price to NAV of 1.06x, sitting at the low end of its valuation range over the past 5 years, as shown below. Analysts have a consensus Buy rating with an average price target of $21 , equating to a potential 30% total return over the next 12 months.
Investor Takeaway
The recent drop in TSLX's share price presents an excellent buying opportunity for income investors. The portfolio is well-positioned with floating rate debt and reasonably low leverage. This, combined with defensive investments should help it weather a potential economic slowdown due to rate hikes.
Lastly, TSLX is now attractively priced at 1.06x NAV, sitting at the lower end of its valuation range over the past 5 years. As such, income investors may want to consider layering into this high-yielding stock at present.
For further details see:
10.5%-Yielding Sixth Street Specialty Lending: A Terrific Opportunity At Hand