2023-03-29 08:00:42 ET
Summary
- We catch up on Q4 results from BDC Sixth Street Specialty Lending and highlight key income dynamics of the portfolio.
- The company continued to grow its net income with a large jump in Q4. The dividend was raised once again and coverage remains high.
- Portfolio quality was strong as non-accruals remain near zero.
- TSLX valuation has recently compressed to a relatively attractive level which allowed us to open a position.
This article was first released to Systematic Income subscribers and free trials on Mar. 21.
In this article, we discuss the latest quarterly results from the business development company Sixth Street Specialty Lending ( TSLX ). The company delivered a strong Q4 with a +3.6% total NAV return, continuing its sector outperformance. TSLX recently saw its valuation deflate relative to the sector average which we view as an attractive entry point.
Quarter Update
Adjusted net income (adjusted for accrued capital gain incentive fees) rose by 36% to $0.64 in Q4. It appears that there was a non-recurring +$0.12 item (Biohaven) in net income so recurring net income still rose a very respectable 11% in Q4.
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The company increased the base dividend for the third consecutive quarter for a year-over-year increase of 12%. It also declared a supplemental dividend of $0.09.
Distribution coverage remains high. With the new base dividend of $0.46 coverage is 139% while, with the Q1 supplemental, it is 116%. As many other BDCs, the company is worried about a drop in short-term rates and therefore plans to run at a high level of coverage for the time being. Spillover income was estimated to be $0.77 or close to 2 months of the base dividend.
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The NAV rose slightly, primarily as a result of retained income.
Income Dynamics
Net new investments remained positive for the third quarter in a row.
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Leverage was not much different and remains in the 0.9x - 1.25x target range.
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Portfolio yield increased by 1.2% over the quarter due to the impact of base rates. Cost of debt, however, increased by about the same.
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TSLX is unusual in that all of its debt is floating-rate. Its fixed-rate unsecured debt is swapped to floating-rates via interest rate swaps. To our knowledge it's the only BDC that swaps their entire bond issuance. OCSL has swapped one of their two bonds.
The direct result of this is that TSLX has a relatively high cost of debt for its high rating. Other investment-grade BDCs have a cost of debt that is 1-1.5% below the level of TSLX. A number of BDCs were able to lock in coupons of 2-3% in 2021 when interest rates were low. By contrast TSLX pays coupons of around 7% on its bonds. If there is a silver lining, it 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.
TSLX
Another unusual feature of the company's debt stack is its large undrawn amount under its credit facility of $570m. This is more than a third of its total debt. The company pays an undrawn fee of 0.375% on this amount which further adds to its interest expense. Undrawn fees on committed but unutilized credit facilities are very common. What's odd is the large size that TSLX has for the undrawn amount. Management refer to it as offering them tremendous flexibility and is worth the cost. However, there is no reasonable scenario where the company would be able to utilize anything near that amount as it would blow up their leverage.
The company's floating-rate debt profile translates into a relatively low net income beta to short-term rates that is 45% below the median BDC.
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Portfolio Quality
Non-accruals remained near zero for a couple of years running now - an impressive profile.
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Portfolio quality , as indicated by internal ratings, was flat.
The company had net realized gains for the fifth quarter in a row. There was only a single quarter of net realized losses in the last two years.
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PIK moved back below the sector average level.
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Management indicated that weighted average interest coverage as of year-end base rates decreased from 2.6x to 2.2x. This is not dissimilar to the broader sector.
Amendments picked slightly however management indicated that the overall level is still benign.
Possibly the most interesting position in the portfolio is the asset-backed loan to Bed Bath & Beyond (BBBY) . The company narrowly avoided a bankruptcy with a bit of financial engineering from Hudson Bay Capital Management. The deal is complicated but BBBY gets $225m from Hudson Bay in exchange for shares that Hudson Bay can convert into common shares and sell on the market. Much depends on where the stock actually trades and so far the deal does not appear to be working as the stock price is down by a half over the past month. It's hard to say whether this is material for the $55m TSLX position. Management said it's already marked to liquidation value (impressive as it's pretty much marked at par). The position is 4% of net assets.
Return And Valuation Profile
TSLX features one of the strongest return profiles in the broader BDC sector with a total NAV return close to double the average company over the 3-7Y horizons.
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The company has consistently outperformed the BDC sector with only one quarter of underperformance in the last 5 years. On a twelve-month trailing basis (yellow line), it has consistently outperformed. The level of outperformance has moved lower over the past couple of years and is worth watching. This is mitigated by the company's relative valuation improvement and likely explained by a lower deal / exit level environment which leads to a more muted fee and equity upside profile. We expect outperformance to increase once the broader venture environment improves.
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It can be difficult to compare performance and valuation at the same time. One way we like to do it is to produce a ratio of the 3Y total NAV return to the current valuation which combines the two key metrics into one, presenting a kind of total return per unit of valuation. On this metric we see that TSLX looks very strong.
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TSLX valuation premium to the broader sector has fallen to around 15%. This sounds high, however, this is well below its average premium of around 24% over the last 5 years. And, as discussed above, its performance premium remains well above its valuation premium.
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Points Of Differentiation
TSLX operates in the meaty part of the middle-market segment with a portfolio weighted-average EBITDA of $46m. This is well below the BDCs focused on the upper segment such as ARCC, OCSL, ORCC and above those focused on the lower segment such as FDUS and CSWC.
The company has a high amount of first-lien holdings at 90% - 11% above the median BDC. Its equity allocation is in line with the median at 6%.
TSLX has a relatively unique element in its portfolio which is its retail asset-backed lending particularly in the distressed part of the market. Out of 25 transactions, 9 have gone through the bankruptcy process with no losses. The unlevered return of fully realized ABL investments is 21%.
Takeaways
The recent valuation compression of TSLX relative to the sector provides an attractive entry point in our view. The company continues to generate strong returns and outperform the sector. Its higher-quality first-lien profile is also an asset in the current environment.
For further details see:
Sixth Street Specialty Lending: Opening A Position In This High-Performing BDC