Sixth Street Specialty Lending, Inc. annual report, FY2023

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Business context and reporting period

Sixth Street Specialty Lending, Inc. (NYSE: TSLX) is an externally managed business development company and regulated investment company focused primarily on originating loans to U.S. middle-market businesses. This Form 10-K covers the fiscal year ended December 31, 2023; it also reports fourth-quarter results and selected 2022 comparisons. Amounts below are U.S. dollars.

Financial and portfolio metrics

  • Investment income: $438.1 million for 2023, up from $309.3 million in 2022. Interest income rose to $418.8 million from $297.6 million, driven by higher reference rates and a larger average portfolio.
  • Net investment income: $196.4 million, versus $166.3 million in 2022. Net expenses increased to $239.3 million from $140.4 million, primarily because of higher interest expense and incentive fees.
  • Operating results: Net increase in net assets from operations was $222.0 million, compared with $108.1 million in 2022. Net realized gains were $12.4 million; net unrealized gains were $13.2 million, reversing the $74.9 million unrealized loss in 2022. Basic and diluted earnings per share were $2.61, versus $1.38.
  • Fourth quarter: Investment income was $119.5 million, net investment income $54.7 million, and increase in net assets from operations $51.2 million. Quarter-end NAV was $17.04 per share, compared with $16.48 at year-end 2022.
  • Portfolio: Fair value was $3.283 billion, up from $2.788 billion, across 136 portfolio company investments (including structured credit series), versus 121 a year earlier. First-lien loans were 91.3% of portfolio fair value; secured debt was 92.4%. Weighted-average yield on debt and income-producing securities at fair value was 14.1%, versus 13.5%.
  • Credit quality: Investments on non-accrual totaled $20.7 million, or 0.6% of fair value, compared with $0.2 million and approximately 0.0% in 2022. Adviser risk ratings of 3 rose to 3.9% of portfolio fair value from 0.8%; rating 5 was 0.6%, versus approximately 0.0%.
  • Cash flow and liquidity: Operating activities used $236.8 million, versus $224.5 million used in 2022, reflecting investment funding and portfolio cash receipts. Financing activities provided $236.3 million. Year-end cash and cash equivalents were $25.2 million, including $24.0 million restricted as swap collateral; reported revolver availability was $820.2 million, subject to borrowing-base and asset-coverage limits. Unfunded commitments to existing portfolio companies were $316.1 million.
  • Debt and leverage: Outstanding principal debt was $1.837 billion, up from $1.517 billion; carrying value was $1.780 billion. Asset coverage was 181.6%, down from 188.6%, against the 150% regulatory minimum. Average debt outstanding rose to $1.706 billion from $1.342 billion, and average borrowing cost to 7.3% from 3.9%. Interest expense, including financing items and swaps, increased to $133.7 million from $63.0 million.
  • Distributions and NAV: Dividends declared were $2.10 per share for 2023 versus $1.84 in 2022, including base and supplemental distributions. NAV per share increased to $17.04 from $16.48. The company issued 5.175 million shares in a 2023 offering and through its over-allotment, raising $89.2 million net; no shares were repurchased during 2023.

Material changes versus the prior comparable period

  • Income and net investment income increased, but the rise in borrowing costs and average debt materially lifted expenses; net expenses grew faster than investment income.
  • Portfolio fair value expanded, while annual new investments funded declined to $808.4 million from $864.0 million and exits and repayments declined to $469.1 million from $653.8 million. New investment commitments net of syndications were $958.6 million, versus $1.084 billion.
  • Credit indicators weakened modestly: non-accrual investments and rating-3 positions increased from low 2022 levels. Total unrealized results improved from a large 2022 loss to a modest gain.
  • Debt principal increased, asset coverage declined, and the company issued $300 million of 2028 Notes in August 2023 at a 6.95% stated coupon. The $150 million 2023 Notes matured and were repaid in January 2023.

Outlook, risks and unusual items

  • The filing provides no quantified earnings or investment guidance. Management describes middle-market lending conditions as offering potential attractive opportunities, while warning that economic, market and financing volatility may impair borrowers, valuations, funding access and results.
  • Nearly all debt investments bear floating rates and have floors, but higher rates may also strain borrowers and raise financing costs. A 100-basis-point rate increase was estimated to add $12.8 million to annualized net interest income, assuming the year-end balance sheet and no management actions.
  • Most investments lack readily observable prices: $3.209 billion of investments were classified as Level 3 at year-end. Fair-value estimates are subjective; KPMG identified Level 3 investment valuation as a critical audit matter. The auditor nevertheless gave unqualified opinions on the financial statements and internal control over financial reporting.
  • Other key risks include borrower defaults, illiquidity, concentration, leverage and refinancing needs, conflicts and fee incentives involving the external adviser, and possible dilution from below-NAV share issuance. The company’s authorization to issue shares below NAV expires May 25, 2024.
  • The company accrued $2.3 million of federal excise tax for 2023 and retained approximately $91.6 million of taxable income and capital gains for liquidity. RIC status and distribution requirements remain important to its tax treatment.
  • Subsequent event: On January 8, 2024, the company issued $350 million of 2029 Notes at a 6.125% stated coupon; proceeds were used to repay revolver borrowings. Management reported no material pending or threatened litigation and no material cybersecurity incident in the last three fiscal years.

Important facts for investors to verify

  1. Reconcile the deterioration in non-accruals and risk ratings with portfolio company disclosures, valuation marks and subsequent repayments or restructurings.
  2. Assess the sensitivity of NAV and earnings to Level 3 valuation assumptions and the extent to which valuation changes are supported by realizations or observable transactions.
  3. Confirm current asset coverage, covenant headroom and usable revolver availability, considering the $316.1 million of unfunded commitments and collateral requirements.
  4. Review refinancing and interest costs, particularly the $347.5 million 2024 Notes maturity, and the effect of the post-year-end 2029 Notes issuance on revolver usage and total debt.
  5. Compare dividends with recurring cash income, taxable income, PIK accruals and excise-tax needs; verify the ongoing sustainability of base and supplemental distributions.