Sixth Street Specialty Lending, Inc. quarterly report, Q1 FY2023

Business context and reporting period

Sixth Street Specialty Lending, Inc. (NYSE: TSLX) is a business development company and regulated investment company that primarily originates loans to U.S. middle-market businesses. This unaudited Form 10-Q covers the three months ended March 31, 2023; balance-sheet comparisons are with December 31, 2022. Unless stated otherwise, dollar amounts below are in millions.

Financial and portfolio highlights

Investment income was driven mainly by interest: interest from investments was $93.1, compared with $65.4 a year earlier. Net investment income was 12.73% of average net assets on an annualized basis, versus 11.16%; the annualized net expense ratio was 15.89%, versus 9.91%. The portfolio’s weighted average yield on debt and income-producing securities at fair value was 13.9%, up from 13.5% at year-end.

Debt had a $1,629.4 principal balance and $1,563.0 carrying value at March 31. The revolving facility had $603.1 of stated availability, subject to borrowing-base and asset-coverage limits. Cash and cash equivalents were $25.7, including $16.2 of restricted cash. Asset coverage was 183.3%, compared with 188.6% at December 31; the statutory minimum is 150%. The company reported compliance with its debt covenants.

The company declared $0.55 per share in Q1 dividends ($0.46 base and $0.09 supplemental), compared with $0.52 a year earlier. It funded $138.9 of investments and reported $50.8 of exits and repayments. Unfunded portfolio-company commitments totaled $330.4.

Material changes versus the prior comparable period

• Investment income increased 43%, and net investment income increased 20%, reflecting higher reference rates and a larger asset base.
• Net expenses rose to $53.2 from $31.4. Interest expense increased to $28.5 from $9.6 as average debt rose to $1,569.4 from $1,211.0 and the average borrowing rate increased to 6.7% from 2.3%.
• Net realized gains declined to $5.2 from $13.7. Unrealized gains were $4.8, versus unrealized losses of $8.5 in Q1 2022; operations nevertheless increased to $53.0 from $40.9.
• Operating cash flow shifted to a $73.5 use from an $81.2 source, principally reflecting net investment funding. Financing cash flow was a $73.6 source, including $457.6 of borrowings, $345.5 of debt repayments and $38.5 of dividends paid.
• The $150.0 of 2023 Notes matured and was repaid in cash in January. Total principal debt at quarter-end was higher than at year-end, while stated revolving-facility availability was lower.

Outlook, commentary, risks and unusual items

The filing provides no specific earnings or dividend guidance. Management says it expects cash, operating cash flows and available credit capacity to support near-term investment activity and operations, subject to the facility’s limitations. It describes middle-market lending as offering attractive opportunities, but this is management’s view rather than a forecast.

• Interest-rate exposure is significant: 99.2% of debt investments by fair value had floating rates, all subject to floors. The company’s sensitivity analysis estimates that a 100-basis-point increase would raise annualized net interest income by $11.7, while a 100-basis-point decrease would reduce it by $11.7, assuming the balance sheet remained constant.
• Leverage magnifies gains and losses. Borrowings were $1,629.4, and asset coverage was 183.3%; covenant compliance and access to capital markets remain important to liquidity.
• Most investments are illiquid and valued using significant unobservable inputs (Level 3). Fair values may differ materially from proceeds in a forced sale or eventual realization.
• Non-accrual investments were $19.8 fair value, or 0.7% of the portfolio, versus $0.2 at year-end. The filing identifies American Achievement as on non-accrual; its fair value was substantially below amortized cost. Bed Bath & Beyond’s ABL FILO loan was carried at $68.3 fair value; the filing records a full valuation allowance against a separate $8.1 make-whole claim because collectability was uncertain.
• Other exposures include $330.4 of unfunded commitments, foreign-currency investments and borrowings, derivative collateral requirements, and portfolio-company credit deterioration. Management reported no material pending or threatened litigation and no subsequent event requiring disclosure.
• The adviser accrued $1.8 of capital-gains incentive fees in Q1; those fees were not contractually payable as of March 31. The company also estimated approximately $71.0 of taxable income carried forward for shareholder distribution, subject to final tax-return calculations.

Most important facts for investors to verify

1. Whether higher portfolio yields continue to exceed the rising cost of debt, fees and other expenses.
2. Borrowing-base-adjusted credit availability, asset coverage headroom, covenant compliance and the funding plan for $330.4 of portfolio commitments.
3. Credit status, valuation assumptions and expected recoveries for non-accrual and other watch-list investments, including American Achievement and Bed Bath & Beyond-related exposures.
4. Whether Level 3 investment marks and reported gains can be realized, given the portfolio’s illiquidity and valuation sensitivity.
5. The sustainability and tax character of dividends relative to investment income, taxable income and cash generation.