Sixth Street Specialty Lending, Inc.

Moat: 2/5

Understandability: 2/5

Balance Sheet Health: 4/5

Sixth Street Specialty Lending, Inc. is a specialty finance company focused on providing direct loans to middle-market companies, offering a mix of first-lien and second-lien credit, along with some equity co-investments.

Investor Relations Previous Earnings Calls

The moat, understandability, and balance sheet health scores reflect a conservative evaluation to ensure a margin of safety in any assessment.

TSLX’s business revolves around direct lending to middle-market companies, a niche that presents unique opportunities and challenges. The company doesn’t operate in a highly diversified pool of clients. Its focus remains on a relatively concentrated group of borrowers, which also impacts its moat and risk factors.

Business Overview:

Revenue Distribution: TSLX generates revenue primarily through interest income from its loan portfolio, with a smaller portion coming from fees, dividends, and other income sources. The credit portfolio generally includes a mix of first-lien and second-lien loans, typically secured by the assets of the borrower company. The average loan size in the portfolio has been in the range of $30-40 million.
Industry Trends: The middle market is undergoing rapid changes, particularly around digitalization, supply chain disruptions, and shifting consumer preferences, these trends increase credit risks. In the overall credit market, direct lending has been growing but also attracting more participants. The credit conditions have been tight with high interest rates.
Margins: TSLX’s operating margin fluctuates based on several factors but seems to be mostly dependent on the interest rate increases. For the third quarter 2023, it was around 67 percent. Interest income has become increasingly significant, but it is important to monitor how rising interest rates affect the ability of their borrowers to service their debts. This also translates into a slight increase in non-performing loans. The profitability is also dependent on efficient operations management, to keep the expenses to a minimum. This needs to be kept in check during growth phases.
Competitive Landscape: The competitive landscape is fragmented and includes other publicly traded and privately held business development companies (BDCs), commercial banks, credit funds, and other private capital providers. Differentiation in the credit landscape has to be on pricing and quality. TSLX differentiates itself through a disciplined and consistent approach towards providing loans that are structured to protect investors, with good risk-return trade-offs. The company also leverages its extensive network and expertise to source quality deals.
What Makes TSLX Different: Sixth Street, in general, is a very big and global alternative asset management company. TSLX operates under the umbrella of a bigger alternative investment management company and benefits from economies of scale and their experience, which help it to access better quality deals and assess risk better. TSLX is a specialty finance company and not just a normal BDC. Further, TSLX offers some specific loans, in specialized credit, asset backed finance, and private lending, which differentiates them from other players. The company is primarily targeting companies that are considered to be “middle market companies”, or what TSLX terms ‘lower-middle market companies’, which are different from larger companies.
Recent Concerns/Controversies/Problems: There have been concerns over potential slowdowns in the economy, leading to higher defaults and lower credit ratings for their client companies. However, TSLX has repeatedly said in earning calls that most of its investments are in stable businesses. Interest rate fluctuations and inflation also have led to some uncertainty about the borrowers’ abilities to pay back the debts. Despite higher interest rates increasing interest income, it has also been increasing the interest payments for the companies they are giving loans to. TSLX also reported a decrease in management fees which the management attributed to a higher percentage of new investments being in credit instead of the management fee-earning assets.

Financials in Depth:

Revenues: Investment income is mainly generated from interest and fees on its direct lending portfolio. Total investment income rose to $442.6 million in the third quarter of 2023 which is 14.5% higher than the previous year’s income.
Expenses: Operating expenses have increased drastically to 130M from 110M in last quarter as a result of the increase in interest expense for TSLX itself, the fund also needs to incur an expense on the loans given out. However, the management fee of TSLX has decreased slightly, despite an increase in total earnings as the management fee is calculated on equity invested by the investors.
Profitability: Net income for the three months ended September 30, 2023, was $255.6M. In the last two quarters, the company has shown substantial growth and the profits are very strong. However, the rise in profit has been primarily due to the increase in interest rates rather than internal business activities of the company. The high profits seem to be more transitory in nature, rather than permanent.
Balance Sheet: Total assets are at about $6.4B while liabilities are at about $2.6B. The company has significant financial flexibility in terms of its debt and a low leverage ratio of 1.2x compared to other financial institutions. TSLX can also generate an annual free cash flow of more than 1.1B.
Debt & Leverage: The company has a good debt structure, with the recent increase in rates likely to benefit the fund. TSLX has significant capacity in its revolving credit facility. The debt-to-equity ratio of the company hovers around 1.2x, but it is important to monitor it regularly. As the company is exposed to loans of smaller and medium size companies, any economic downturn will affect them disproportionally.
Key Ratios: Net asset value (NAV) per share has been in the range of 16.3 to 17.6 in the past year. ROE (Return on Equity) was 26.1% in September of 2023. This high ROE might be partly inflated and has to be taken with a grain of salt, since the interest rate has increased. Also, the company has a significant dividend yield of about 10-12%.
Other metrics: TSLX has good credit quality in its loan portfolio, with a weighted average yield of 12.9% at the end of the last quarter. However, the non-accruals ratio has increased slightly to 1.8%. As of December 31st, 2022, their annualized base management fees were 1.5% of gross assets and then an Incentive Fee of 20% on pretax net income above 7% hurdle rate.

Moat: 2 / 5

TSLX’s moat is weak, due to not having a substantial business moat. While the business model provides high ROIC through its loans, there isn’t a strong business advantage that protects it from competitors in the long term. The management of TSLX makes it a little better but still not enough to qualify for a higher rating.

Justification:

Limited Differentiation: TSLX operates in the direct lending space which is fairly fragmented and competitive. It is harder for them to have a considerable advantage over their competitors. The ability to differentiate is difficult and it is easy to compete through low prices.
Lack of Customer Lock-in: Borrowers have flexibility in moving from one lender to another, making TSLX’s clients relatively more prone to switching lenders if they find a better offer. While client relationships may be strong, there isn’t a strong economic incentive for the borrower to stay with TSLX.
Dependence on Management Expertise: Much of TSLX’s success hinges on the expertise of its investment team to select good loans, manage risk, and create value. But their skill and excellence can be very easily replicated by the management teams of other firms as well.
Brand Recognition: The brand name of TSLX itself is not a strong recognizable one. They do use their parent company’s brand to leverage some of its recognition. However, since most of the business is carried out at the parent level, it is difficult to rate this as a sustainable advantage. The other lenders can provide the same kind of support in a similar fashion and it is not really a differentiator.
Switching Costs: The customers they service may sometimes incur switching costs to move, but often it is not significant enough to give TSLX strong pricing power, or lock them into using only TSLX loans.
Network Effect: TSLX doesn’t have any form of network effect that could improve its competitiveness. The more customers they have does not make it more attractive for new clients.
Economies of scale/scope: Being part of a large group like Sixth Street, TSLX can somewhat leverage this advantage, but the actual business of lending for TSLX requires a specialized focus and is not dependent on the overall scale of the organization.

Risks to the Moat:

Credit Risk: The loans that TSLX provides are susceptible to economic downturns and financial issues of their borrowers. If the economic conditions worsen, their borrowers may not be able to repay the loans, leading to an increase in non-accruals and even loan losses, which negatively affects the overall profitability of TSLX.
Interest Rate Risk: Higher interest rates might affect TSLX in both ways, if interest rates increase too fast, their borrowers may face financial challenges making them unable to service debts. Similarly, if the rate on their own debt increases, then it would lead to lower margins and profitability. While both of these may affect profits, it can be managed.
Competition Risk: Because the lending business is fairly fragmented and is relatively easy to enter, there are many participants. These participants compete for clients by having lower costs and by providing low loan rates. Increased competition might make it harder for TSLX to win quality deals. This may lead to a decrease in return on invested capital.
Regulatory Risk: As a financial company, TSLX is highly regulated. Changes in regulations or laws may hamper the business and reduce flexibility. Compliance-related costs can also increase the expense side for the company.

Business Resilience:

Diversification across Portfolio: TSLX is somewhat protected by its diversified pool of debt and equity securities, but their performance is closely tied to the overall economic conditions.
Capital Structure: TSLX’s capital structure is favorable, due to its low leverage. The company is not over-leveraged and has ample ability to get more funding at reasonable rates to meet business needs.
Management Experience: The management team has extensive experience and understanding of the middle market and credit space, and they should be able to navigate challenging market conditions.
Expertise in structuring deals: The company is very adept in structuring and negotiating terms with the borrowers which will protect them in times of need.
Established Relationships: TSLX has good long term relationships with the borrowers and are able to provide specialized credit and customized financial solutions to meet their demands, creating a kind of barrier to entry for other similar players.

Understandability: 2 / 5

Justification:

Complex Financials: TSLX’s financial statements can be complex, requiring an understanding of various credit measures, derivatives, and valuation techniques. It can be quite difficult to accurately assess the long-term value of the business due to its use of complex financial instruments.
Dependence on macroeconomic factors: Its overall business is highly dependent on factors such as interest rates, economic conditions, and credit ratings of its clients. These factors make it hard to predict future performance.
Specialized Lending: The direct lending business has special terminology, which requires a very deep understanding of the business.
Need of deep analysis: Understanding a BDC requires deep analysis of not only the financials but also all the underlying companies they have invested in. As the company itself is very much dependent on the success of these companies.

Balance Sheet Health: 4 / 5

Justification:

Adequate Equity and Assets: TSLX maintains a high equity base with reasonable debt, thereby giving it a relatively stable financial position.
Low Leverage: The company has a relatively low leverage ratio, giving it good ability to take on more debt in the future.
Cash Flow: The company has good positive free cash flow from operations.
Dependence on Debt Financing: In this type of lending business, there’s always the risk of over-reliance on debt for generating earnings. This must be continuously monitored by the company’s management.
Risk of borrower bankruptcy: Their borrowers are often smaller, illiquid companies that could go bankrupt. This creates a credit risk on the portfolio of TSLX. Although this is part of their business, it also shows the high risks they are exposed to.

The overall picture of TSLX is of a company with decent prospects, high dividend yield, and good growth. But to get a thorough understanding of it requires a good analysis of the sector. TSLX’s business is primarily dependent on a few key components, and these include the interest rate, the quality of management, and the diversification of the portfolio. The lack of a strong moat along with some major risks makes the company less appealing, compared to a very stable, wide-moat business.