Sixth Street Specialty Lending, Inc. quarterly report, Q3 FY2022

Sixth Street Specialty Lending, Inc. — Q3 2022 Form 10-Q

Reporting period: Three and nine months ended September 30, 2022. Sixth Street Specialty Lending is a business development company (BDC) that primarily originates loans to middle-market companies and has elected regulated investment company (RIC) tax treatment. Figures are in U.S. dollars; financial statement amounts are in millions unless otherwise noted.

Financial and portfolio highlights

MetricQ3 / September 30, 2022Comparable period / prior year-end
Investment income$77.8 million$71.2 million in Q3 2021
Net investment income$37.2 million$36.5 million in Q3 2021
Net increase in net assets from operations$34.4 million; basic EPS $0.43$55.0 million; basic EPS $0.75 in Q3 2021
Net realized and unrealized gains (losses)$(2.7) million$18.5 million in Q3 2021
Net investment income / investment incomeApproximately 47.8%Approximately 51.2% in Q3 2021
Investment portfolio fair value$2,806.1 million$2,521.6 million at December 31, 2021
Net asset value per share$16.36$16.84 at December 31, 2021
Debt outstanding principal / carrying value$1,536.8 million / $1,457.0 million$1,213.9 million / $1,186.0 million at December 31, 2021
Cash and cash equivalents$30.3 million, including $15.6 million restricted$16.0 million at December 31, 2021
  • Nine-month results: Investment income was $209.2 million versus $200.3 million in 2021; net investment income was $113.7 million versus $96.2 million. Operations generated $61.8 million versus $170.0 million, reflecting net unrealized losses of $68.4 million versus gains of $67.7 million.
  • Cash flow: Operating activities used $278.8 million in the first nine months, primarily reflecting $735.9 million of investment purchases and originations, partly offset by $412.2 million of repayments and proceeds. Financing activities provided $293.1 million, including $1,024.6 million in borrowings and $586.6 million in debt repayments. Dividends paid were $115.2 million.
  • Liquidity and leverage: Revolving credit facility availability was $845.7 million, subject to borrowing-base and asset-coverage limits. Asset coverage was 186.6%, down from 205.4% at year-end 2021; the statutory minimum disclosed is 150%.
  • Portfolio profile: The company held investments in 118 portfolio companies, compared with 72 at year-end 2021. At fair value, 90.4% was first-lien debt and 7.7% equity and other investments. 98.9% of debt investments bore floating rates, all with interest-rate floors. Weighted average debt-investment yield at fair value was 12.3%, up from 10.0% at year-end.
  • Credit quality: Management classified 89.0% of portfolio fair value as risk rating 1, 9.8% as rating 2, 1.2% as rating 3, none as rating 4, and $0.2 million as rating 5. Non-accrual investments had $0.2 million fair value at September 30.

Material changes and management commentary

  • Q3 investment income increased mainly because higher reference rates lifted interest earned on floating-rate loans. Higher average debt and funding rates also pushed Q3 interest expense to $18.9 million from $9.9 million; average debt rose to $1,490.9 million from $1,240.8 million and its average rate to 4.4% from 2.3%.
  • Management attributed the nine-month unrealized investment losses primarily to widening credit spreads, with some impact from negative company-specific developments and reversals of prior gains. Portfolio fair value exceeded amortized cost by $13.3 million at quarter-end, compared with an $89.6 million excess at year-end 2021.
  • During Q3, the company funded $274.4 million of investments and recorded $15.8 million in exits and repayments. Gross originations were $1,910.1 million, including $1,525.5 million syndicated or sold down; net new commitments were $384.6 million.
  • The $100.0 million principal balance of 2022 Convertible Notes matured on August 1. Holders converted $79.2 million, settled partly through issuance of 4,360,125 shares valued at $78.1 million; the remaining balance was settled with cash, including use of the revolving facility. The notes and related swaps were terminated at maturity.
  • Declared dividends totaled $1.39 per share for the first nine months of 2022, compared with $2.61 in 2021, which included a $1.25 special dividend. The Q3 base dividend was $0.42 per share. The board determines dividends; the filing does not provide a quantified earnings or dividend forecast.
  • Management said cash and available facility capacity were expected to cover near-term investment activity and operations, while noting broader uncertainty from inflation, economic conditions, capital-market access, interest rates, and borrower performance. The company disclosed no material pending or threatened litigation and stated disclosure controls were effective.

Risks, contingencies, and unusual items

  • Portfolio-company funding commitments totaled $393.6 million at September 30, up from $332.1 million at year-end. These commitments may be drawn on borrower demand and are a liquidity consideration.
  • $150 million of 2023 Notes were due January 22, 2023. The revolving facility’s principal commitments were $1.585 billion, with most revolving-period availability extended to April 2026 and stated maturity to April 2027.
  • Most investment fair values rely on Level 3, unobservable inputs: $2,709.7 million of investments at quarter-end. Actual proceeds in a forced sale could differ materially from reported fair values.
  • Interest-rate swaps had a reported fair value of $(58.9) million, netted against collateral; $15.6 million was pledged as restricted cash. Derivative collateral requirements can change and failure to meet a margin call could trigger default.
  • Management’s static sensitivity analysis estimated annualized net interest income would increase $11.3 million with a 100-basis-point rise in base rates and decline $2.8 million with a 25-basis-point fall. The filing cautions that this analysis excludes changes in credit quality, portfolio composition, and market conditions. Higher rates may also strain borrowers and increase funding costs.
  • Potential conflicts from the external adviser’s related funds, leverage, and incentive-fee structure remain relevant. The company also had authorization to issue shares below NAV, subject to board approval and conditions; such issuance could dilute existing shareholders.

Important facts for investors to verify

  • How the $393.6 million of unfunded portfolio commitments, the 2023 Notes maturity, and the revolving facility’s borrowing-base limits affect available liquidity.
  • Whether portfolio marks, particularly Level 3 valuations, and credit ratings remain supportable as spreads, rates, and borrower fundamentals change.
  • Trends in non-accruals, watch-list ratings, PIK income, and borrower ability to service floating-rate debt.
  • Whether investment-income growth continues to exceed rising interest and other expenses, and whether distributions are supported by taxable income and cash generation.
  • The effect of the convertible-note share settlement and dividend reinvestment issuances on per-share NAV and future earnings.