Sixth Street Specialty Lending, Inc. (NYSE:TSLX) is a specialty finance focused business development company (or BDC), which provides a diversified set of financing options to small and medium size enterprises domiciled in the U.S.
Looking back at the past 3-year period, TSLX has underperformed its peers, which have managed to benefit more from the increased demand for private credit.
If we look deeper into how TSLX is structured, we can quickly understand what has been the main reasons for the lagging performance. In essence, TSLX’s conservative capital allocation policy has capped the growth momentum, resulting in more flattish returns relative to the direct peers.
Yet, in my opinion, this has created an attractive entry point, where on a relative basis TSLX looks now more interesting and considering the uncertain macroeconomic backdrop, TSLX’s conservatism should come in handy.
Below I have outlined three key reasons why I think that TSLX is a solid investment, which is worth incorporating in the portfolio.
#1 – Minimal idiosyncratic exposures and relatively safe exposures
TSLX’s investment focus in the first lien, which as of Q2, 2023 accounted for 91% of the total asset base. The remaining part is split among second lien, structured credit, mezzanine, and equity investments.
Being exposed to a first lien structure inherently comes with a fair degree of safety as in the event of default, TSLX would be one of the first in line to capture the remaining value. Usually, when companies struggle and have to make a decision where to optimize cash flows, dividends, and distributions to preferred and mezzanine holders are cut. In other words, first-lien creditors are almost always served first.
An additional safety factor, which is important to take into account is the net LTV (or loan to value) ratio of TSLX’s underlying investments. The companies to which TSLX has provided credit or equity proceeds are one average carrying very sound balance sheets with an average net LTV of 31%. It depends on the industry, but the general rule of the thumb is that a net LTV of 50% is considered somewhat risky especially in the context of the prevailing interest rate dynamics. TSLX is nowhere close to that.
Moreover, as TSLX has expanded its asset base, the diversification effect has kicked in contributing to a more de-risked exposure. The great thing here is that cyclical entities (excluding energy), which tend to experience hardships during environments of economic distress constitute only ~ 8% of the total TSLX’s asset base.
The presence of a solid diversification is nicely captured by the above-reflected graphs. The single largest security (or company) exposure of TSLX accounts only for 2.5% of the total portfolio. At the same time, the largest sector exposure consumes only 15.7% of the total portfolio, which is uncommon in the BDC space (i.e., usually, the single sector exposures concentrate around 25% of the portfolio).
#2 – Prudent funding
In the private credit business, sources of funding and their structures play a critical role for creating value for shareholders.
In TSLX’s case we can see that the management has assumed a rather conservative approach in sourcing external funding to cover the incremental loan proceeds (i.e., investments).
First of all, TSLX has never issued additional equity below the NAV.
Since the IPO, TSLX has 98% of the all trading days traded above the NAV, which has encouraged the management to issue fresh equity in a value accretive manner for the existing shareholders.
This additional capital has helped TSLX accelerate diversification and finance high-yielding projects.
In addition, the assumed leverage of TSLX is nicely structured allowing the Fund to not worry about major refinancings until 2028. Most of the attracted debt is based on a variable rate to align the asset and liability risk exposures. In other words, most of the issued financing by TSLX is based on a floating or variable rate. Therefore, having a variable rate funding allows TSLX to mitigate the interest rate risk without costly derivatives.
Finally, the existing liquidity is strong, amounting to $965 million. This is more than sufficient to fully repay the maturing borrowing until 2028 and invest in new opportunities.
#3 – Juicy cash flows
The current interest rate dynamics warrant an appealing equity story of the private credit vehicles like TSLX.
In the chart above, we can see how TSLX’s lending and funding approach has led to a solid spread between the cost of financing and the yield at which the credit has been issued to the underlying companies. For investors this means that the returns move in line with the interest rates, thus providing stability in the real return component (which is not that common in the overall investment universe space).
Looking at TSLX’s ability to cover dividends, we can safely conclude that there is sufficient headroom for investors to not worry about potential dividend cuts. In fact, even on a cash flow basis, TSLX remains net positive after dividends, which provides additional funding to grow internally.
Last but not least, TSLX’s valuation on a P/E basis as measured by net interest income adjusted for historical dilutions, puts the Fund in a rather attractive position. The key driver for the delta in the reflected valuations is the aforementioned aspect pertaining to TSLX’s equity funding principle. Namely, the fact that TSLX can issue additional equity at premium to NAV accommodates a sound value creation for the existing shareholder base.
The bottom line
In my humble opinion, TSLX is the best of breed when it comes to private credit BDC segment. The recent underperformance has been attributable to the prudent funding and financing policy, which in the context of a looming recession should compensate investors by providing a more pronounced downside protection.
The current dividend of ~ 9.1% coupled with the aforementioned elements of safety makes the investment case attractive.