The following information was previously provided to paid subscribers of BDC Buzz along with:
TSLX target prices/buying points
TSLX risk profile, potential credit issues, and overall rankings
TSLX dividend coverage projections (base, best, worst-case scenarios)
Real-time changes to my personal portfolio
For paid subscribers, please access the full TSLX Deep Dive Projection report at the following link:
Sixth Street Specialty Lending (TSLX) is considered a higher quality BDC that performs well during distressed environments with management that is very skilled at finding value in the worst-case scenarios including previous retail and energy investments. TSLX often lends to companies with an exit strategy of being paid back through bankruptcy/restructuring and proficient at stress testing every investment with proper coverage and covenants. Management has prepared for the worst as a general philosophy and historically used it to make superior returns.
Over the last six years, TSLX has provided investors with annualized returns of 15% and likely headed higher as the company continues to pay special/supplemental dividends. The “Annualized” return shown does not use a simple average but shows the actual compounding of annual returns. This is the true return each year. Please disregard the annualized total returns for 2020 purchases as the time frame is not long enough to accurately reflect.
TSLX Supplemental/Special Dividends
On August 4, 2021, the company reaffirmed its regular quarterly dividend of $0.41 plus another supplemental dividend of $0.02 per share which was just below the previous base case projections of $0.03. TSLX still has around $1.36 per share of undistributed/spillover income.
When calculating supplemental dividends, management takes into account a “NAV constraint test” to preserve NAV per share. This is one of the reasons that management prefers not to pay large supplemental dividend payments even though the amount of undistributed/spillover income continues to grow. However, management also likes to avoid paying excessive amounts of excise tax by “cleaning out” the spillover as it “creates a drag on earnings” which is why the company paid a total of $1.30 per share in supplemental/specials during Q1 2021. Over the last five years, TSLX has increased the amount of supplemental dividends paid:
Most dividend coverage measures for BDCs use net investment income (“NII”) which is basically a measure of earnings. However, some BDCs achieve incremental returns typically with equity investments that are sold for realized gains often used to pay supplemental/special dividends. These BDCs include TSLX, FDUS, GAIN, CSWC, PNNT, TPVG, HTGC, and MAIN.
“We've always been opportunistic about our equity co-invest program. We've invested about $160 million of equity over time. And we're currently at like, 1.7 times NOM, and my guess that will grow because we have a whole bunch of stuff in the book still. So it's been a decent source of returns. I think the average return on fully realized has been in the 40% range. So we'll continue to take our shots. I would say that it's very specific, so we're not asking for equity co-invest in every deal. If it fits into a sector where we have a deep fundamental view of the business and think there are the prospects are good, and the valuation is good, we will ask for it. But it's more rifle than the shotgun and its more I would say actively managed versus kind of a passive strategy of equity co-invest and taking kind of private equity returns across the cycle.”
Over the last two quarters, TSLX had an additional $16.6 million or almost $0.23 per share of net realized gains (mostly due to the sale of its equity position in Capsule Technologies to Philips) to support additional special/supplemental dividends. Equity positions increased from 4% to 6% of the portfolio due to continued appreciation including Caris Life Sciences and Sprinklr, Inc. (CXM) as discussed below.
“Primarily by the unrealized gains and the debt equity conversion of certain investments upon milestone events this quarter, our portfolios equity concentration increased slightly from 4% to 6% on a fair value basis.”
“In May, Caris Life Sciences completed a growth equity round at nearly $8 billion post money valuation, led by Sixth Street’s healthcare and Life Sciences team. Since 2018, TSLX has made relatively small investment in the company's capital structure alongside our affiliated funds, and receive warrants as part of these transactions. Based on the valuation of Caris latest financing round, the fair value of our junior debt, warrant and preferred equity positions increased significantly quarter-over-quarter, contributing to this quarter's unrealized gain.”
As shown below, Caris Life Sciences, Sprinklr, Inc., Validity, Inc., SMPA Holdings and Motus, are marked well above cost and could result in an additional $0.46 per share if sold/exited at previous fair values. It should be noted that Sprinklr, Inc. (CXM) is currently trading 25% below where it was on June 30, 2021, and there is a 180 lockup on the shares.
“Sprinklr, Inc., another one of our portfolio companies and a provider of customer experience management solutions completed its IPO on June 23. We made a small investment in Sprinklr convertible notes, alongside affiliated funds last May. And upon completion of the IPO, our notes automatically converted into common equity. The quarter-end fair value market of our equity position reflects a discount to the company's June 30 closing share price, given the trading restrictions on our equity security, but still represents a 2.5x NOM on our capital invested.”
For Q2 2021, TSLX reported just below its base case projections due to lower-than-expected fee and other income partially offset by a record amount of interest income of almost $60 million. It is important to point out the most of the income during the quarter was recurring (as compared to onetime fee and other income).
“Other fees, representing prepayment fees and accelerated amortization of upfront fees from unscheduled pay downs were $2.2 million, compared to $8 million in the prior quarter. Other income was $1.1 million compared to $2.3 million in the prior quarter. The slowdown in portfolio turnover this quarter, and net portfolio growth allowed us to generate a higher quality of earnings from interest income. For reference 95% of this quarter's total investment income was generated through interest in dividend income, compared to 79% across 2020, and 88% across 2019.”
However, management is expecting increased portfolio activity in Q3 and Q4 2021 including new investments driving higher fee income and interest income which are taken into account with the updated financial projections.
“We have a strong backlog for the second-half of this year, including agent roles on three large financings that total over $1.5 billion in facility size. As you can expect, we're partnering with our affiliated funds and other managers on these transactions, which provides us the flexibility to determine the optimal final hold sizes for TSLX.”
“I would expect that we continue to leg into our financial leverage. We're kind of in the lowest to middle of our financial leverage range. I would expect activity levels to -- activity level fees and some portfolio turnover in the second-half of the year. So, we're going to work hard continue to stay kind of in the one plus range, and we'll given the economic backdrop, I think we're wanting to take it up to 1.15 to 1.25 in this environment.
Also, there will likely be higher amounts of prepayment related income similar to previous quarters (not Q1 2021) likely driving results closer to the best-case projections:
“In the second-half, we expect some rebound in portfolio repayment activity, which would drive a more normalized level of activity related fees for our business. Based on where we stand today, we believe we are on track to meet the high-end or exceed our previously stated guidance range for full year 2021, which corresponds to return on equity of 11.5% to 12%.”
TSLX Dividend Coverage Update
TSLX has covered its regular quarterly dividend by 112% excluding excise taxes and approximately $0.08 per share of capital gains incentive fees which is also excluded by management.
“Our Q2 figures include approximately $0.08 per share of capital gains incentive fees that were accrued, but not paid or payable, related to cumulative unrealized capital gains in excess of cumulative net realized capital gains less any cumulative unrealized losses and capital gains and incentives paid inception to date. Since capital gain incentive fee accrual is a GAAP-related, non-cash item, we believe the adjusted NII and NI, which excludes the impact of the accrual, more accurately portrays the core earnings power of our business.”
TSLX has been improving its net interest margin through lower cost of borrowings including using its revolving credit facility to fund new investments:
“Our weighted average interest rate on debt outstanding decreased slightly quarter-over-quarter by 4 basis points to 2.26%, as a result of a funding mix shift to greater usage of our secured revolver.”
Also, Q2 2021 was the first quarter the company used leverage with a debt-to-equity ratio over 1.00 reducing its base management fee to 1.00%:
“Lastly on expenses, you'll notice that we applied for the first time a fee waiver on base management fees related to this quarter's portion of average gross assets financed with greater than one times leverage. Above that leverage level, base management fees are reduced to an annualized level of 1%. This is the first time since our stockholders approved the application of a 150% minimum asset coverage ratio in 2018, but we have reached this threshold.”
On February 3, 2021, the company issued $300 million of unsecured notes that mature on August 1, 2026 “at a spread to Treasury of 225 basis points”. On February 5, 2021, the company completed an amendment to its revolving credit facility, which increased the commitments from $1.335 billion to $1.485 billion, increased the accordion to allow for commitments of up to $2.00 billion, and extended the maturity to February 4, 2026. As of June 30, 2021, TSLX had $1.1 billion of undrawn capacity on its revolving credit facility.
TSLX maintains a strong balance sheet with 71% unsecured debt with the nearest debt maturity in August 2022 at $143 million, and the weighted average remaining life of investments funded with debt was ~2.4 years, compared to a weighted average remaining maturity on debt of ~4.1 years.
TSLX has around $143 million of convertible notes that could be converted into shares at some point. Management discussed on the recent call and will likely used to “optimize the impact on our NAV per share, ROEs, financial leverage and liquidity position”:
“As mentioned on our last earnings call, we have the flexibility under our 2022 convertible notes indenture to settle in cash or stock or a combination thereof. These notes are not eligible for conversion today, but when it comes time to make a determination on settlement method, our decision will be one that, among other considerations, optimizes the impact on our NAV per share, ROEs, financial leverage and liquidity position.”
TSLX Risk Profile Quick Update
Total non-accruals declined during Q1 2021 due to its first-lien position in American Achievement added back to accrual status. However, the small subordinated position remains on non-accrual.
“Our investments on non-accrual status remains minimal at 0.02% of the portfolio at fair value, representing our restructured sub notes in American Achievement, as discussed on our call in May.”
As discussed in the previous report, American Achievement is a company that manufactures and supplies yearbooks, class rings and graduation products and was discussed on the previous call:
“Our first lien loan for American Achievement remained outstanding post reorg and the interest that we received, while the loan was on non-accrual status, was applied to our loan principal. As part of the restructuring, the lender group received a majority stake of the common equity and subordinated notes in the restructured business. At quarter end, these subordinated notes accounted for all of our outstanding investments on non-accrual status at fair value.”
During Q2 2021, TSLX’s net asset value (“NAV”) per share increased by 2.3% mostly due to equity positions including Caris Life Sciences and Sprinklr, Inc. as discussed earlier.
“Gains on investments drove strong net asset value per share growth. If we were to look at the growth in our net asset value since the onset of COVID through today, which would require adjusting for the impact of special and supplemental dividends, we've grown that asset value per share by 12.2% since year-end 2019.”
Over 92% of the portfolio (up from 85.5% the previous quarter) is categorized as ‘Performance Rating 1’ which are “performing as agreed and there are no concerns about the portfolio company’s performance or ability to meet covenant requirements. For these investments, the Adviser generally prepares monthly reports on investment performance and intensive quarterly asset reviews.”
First-lien debt accounts for around 94% of the portfolio and management has previously given guidance that the portfolio mix will change over the coming quarters with “junior capital” exposure growing to 5% to 7%.
From previous call: “We believe the relative resilience of our portfolio is mostly a result of a deliberate shift we made in late 2014 towards a more defensive portfolio construction. Today, 95% of our portfolio by fair value is first lien and nearly 75% of our portfolio by fair value is comprised of mission critical software businesses with sticky predictable revenue characteristics. These businesses also tend to have variable cost structures that it can be fluxed down to support debt service and protect liquidity in cases of challenging operating environments.”
Management is very skilled at finding value in the worst-case scenarios including previous retail and energy investments. TSLX often lends to companies with an exit strategy of being paid back through bankruptcy/restructuring and proficient at stress testing every investment with proper coverage and covenants. On a previous call, management discussed some of its recent returns from retail investments including Neiman Marcus and J.C. Penney:
“With a strong market backdrop in late March, Neiman issued notes in the high-yield market to refinance its exit term loan, which had call protection of [1.10] at the time of repayment. This call protection, in addition to the acceleration of unamortized OID on our loans, contributed meaningfully to our fees this quarter. Recall on our Q3 2020 earnings call, we disclosed that approximately $4 million of backstop fees related to our exit term loan commitment were booked as OID and that these fees were payable in common stock of the reorg company. Post quarter end, we sold our entire Neiman equity position at a price above our March 31, 2021 mark, thereby fully exiting all of our Neiman investment. Looking back, we’ve been a provider of liquidity and transitional capital for the retailers – for the retailer as its management team navigated through a pandemic and a Chapter 11 process. We believe this has been a fruitful partnership that has allowed both parties to create value for our respective stakeholders. Based on our total capital invested in Neiman since 2019, we’ve generated a gross unlevered IRR of approximately at 25% on our fully exited investments, which includes a post quarter-end sale of TSLX equity position.”
“Turning now to a quick update on J.C. Penney. Recall that in December, upon the company’s emergence from Chapter 11, our prepositioned debt and dip loan positions were converted to non-interest paying instruments, but with rights to immediate and future distributions and cash and other securities. During the quarter, our $13.3 million fair value dip loan position was extinguished in connection with the closing of a PropCo. And we received a small cash distribution, along with equity interest in the PropCo.
At quarter end, our PropCo equity interest had a level 2 fair value mark of $18.1 million. Across Q1, our J.C. Penney investments drove $5.4 million of net realized and unrealized gains or a positive $0.08 per share impact to our NAV this quarter.
“At quarter end, our portfolio’s retail and consumer exposure was 11.4% at fair value, and nearly 80% of this consisted of asset based loans. Cyclical names, which exclude our asset-based retail loans and energy investments, continue to be limited at 4% of the portfolio. And our energy exposure at quarter end was 1.7%.”
Full TSLX Report:
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Each week we provide a balance between easy to digest general information to make timely trading decisions supported by the detail in the Deep Dive Projection reports (for each BDC) for subscribers that are building larger BDC portfolios.
Monday Morning Update – Before the markets open each Monday morning we provide quick updates for the sector including significant events for each BDC along with upcoming earnings, reporting, and ex-dividend dates. Also, we provide a list of the best-priced opportunities along with oversold/overbought conditions, and what to look for in the coming week.
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Friday Comparison or Baby Bond Reports – A series of updates comparing expense/return ratios, leverage, Baby Bonds, portfolio mix, with discussions of impacts to dividend coverage and risk.
BDCs trade within a wide range of multiples driving higher and lower yields mostly related to portfolio credit quality and dividend coverage potential (not necessarily historical coverage). This means that investors need to do their due diligence before buying.