Sixth Street Specialty Lending, Inc. (NYSE:TSLX) Q4 2022 Earnings Call Transcript

Sixth Street Specialty Lending, Inc. (NYSE:TSLX) Q4 2022 Earnings Call Transcript February 17, 2023

Operator: Good morning, and welcome to the Sixth Street Specialty Lending, Inc. Fourth Quarter and Fiscal Year ended December 31, 2022, Earnings Conference Call. As a reminder, this conference is being recorded on Friday, February 17, 2023. I will now turn the call over to Ms. Cami VanHorn, Head of Investor Relations.

Cami VanHorn: Thank you. Before we begin today’s call, I would like to remind our listeners that remarks made during the call may contain forward-looking statements. Statements other than statements of historical facts made during this call may constitute forward-looking statements and are not guarantees of future performance or results and involve a number of risks and uncertainties. Actual results may differ materially from those in the forward-looking statements as a result of number of factors, including those described from time to time in Sixth Street Specialty Lending, Inc. filings with the Securities and Exchange Commission. The company assumes no obligation to update any such forward-looking statements. Yesterday, after the market closed, we issued our earnings press release for the fourth quarter and fiscal year ended December 31, 2022, and posted a presentation to the Investor Resources section of our website, www.sixthstreetspecialtylending.com.

The presentation should be reviewed in conjunction with our Form 10-K filed yesterday with the SEC. Sixth Street Specialty Lending, Inc.’s earnings release is also available on our website under the Investor Resources section. Unless noted otherwise, all performance figures mentioned in today’s prepared remarks are as of and for the fourth quarter and fiscal year ended December 31, 2022. As a reminder, this call is being recorded for replay purposes. I will now turn the call over to Joshua Easterly, Chief Executive Officer of Sixth Street Specialty Lending.

Joshua Easterly: Thanks, Cami. Good morning, everyone, and thank you for joining us. With us today is my partner and our President, Bo Stanley; and our CFO, Ian Simmonds. For our call today, I will review our full year and fourth quarter highlights and pass it over to Bo to discuss our originations activity and portfolio metrics. Ian will review our financial performance in more detail, and I will conclude with final remarks before opening the call to Q&A. After the market closed yesterday, we reported fourth quarter adjusted net investment income of $0.64 per share or an annualized return on equity of 15.5% and adjusted net income of $0.56 per share or an annualized return on equity of 13.6%. As presented in our financial statements, our Q4 net investment income and net income per share, inclusive of the unwind of the noncash accrued capital gains incentive fee expense, were both $0.01 per share higher at $0.65 and $0.57, respectively.

For the full year 2022, we generated net investment income per share of $2.01 or return on equity of 12% and a full year adjusted net income per share of $1.27 or return on equity of 7.6%. The difference between net investment income and net income for the year was driven overwhelmingly by unrealized losses as we incorporated the impact of wider credit market spreads on the valuation of our portfolio. The impact of increased risk premiums was presented throughout nearly every asset class in 2022. During the calendar year, LCD’s first and second lien spreads widened by 135 and 686 basis points respectively. There has been a lot of talk about the lack of volatility in private asset marks. In this regard, we agree with Cliff Asness’s description of this as volatility laundering.

As we said in the past and for the reasons we outlined in our previous public shareholder letter, we believe that using inputs from the market is not only critical but required and determining fair value of assets. Of the $0.75 per share difference between our net investment income and net income results for 2022, the majority, or 57%, was related to unrealized losses from credit spread movements alone that we expect to recover over time as credit spreads tighten or investments are paid off and 20% was driven predominantly from the decline in equity valuations. The remaining difference between net investment income and net income is primarily related to: one, the unwind on our interest rate swaps that are not subject to hedge accounting; and two, the reversal of unrealized gains that flow through net investment income upon realization.

The overall health of our portfolio remains strong with no changes in nonaccruals from the last quarter. For the third consecutive quarter, our Board has increased our quarterly base dividend, raising the figure by $0.01 per share to $0.46 per share to shareholders of record as of March 15 and payable on March 31. Year-over-year, we’ve increased our base dividend by 12.2%. We are also pleased to share that our Board declared a supplemental dividend of $0.09 per share related to our Q4 earnings to shareholders of record as of February 28, payable on March 20. In the near term, we expect that net investment income will exceed our newly established base level due to our increased earnings power. However, we determined $0.46 per share to be an appropriate level based on looking at the forward interest rate curve through 2025, which is subject to changes in the market.

2022 was a year characterized by spread income as a driver of earnings given repayment activity slowed in the wake of increased market volatility. Portfolio turnover, which is calculated as total repayments over total assets at the beginning of the year, was 26% in 2022 compared to 43% and 41% in 2021, 2020, respectively. The wider spread environment naturally caused a slowdown in repayment activity. As a result, fee-generating income represented a smaller portion of our total investment income for the year relative to historical trends. We generated a return on assets, calculated as total investment income divided by average assets, of 11.6% for 2022 compared to 11.3% in 2021, which was a year defined by a record level of repayment activities.

This further highlights the positive impact on the rise in reference rates and driving incremental returns for our shareholders. Our year-end net asset value per share, adjusted for the impact of the supplemental dividend that was declared yesterday, is $16.39, and we estimate that our spillover income per share is approximately $0.77. We would like to reiterate that our supplemental dividend policy is motivated by: one, rig distribution requirements; two, not burning our returns with the excess friction costs incurred through excise tax; and three, the goal of steadily building net asset value per share over time. Before passing it to Bo, I’ll spend a moment on how we’re thinking about the broader macroeconomic environment. Big picture, we’re cautious.

But when we think about our portfolio, we are constructive on how we are positioned for the road ahead. The U.S. economy faces a number of headwinds in 2023 that are largely the result of inflation and the resulting shift in monetary policy in 2022. The restrictive monetary environment will surely have an impact on growth. The idea of a near-term Fed pivot remains challenging until job growth slows and the consumer weakens. In summary, it feels like we’re living in a transitionary period, with restrictive Fed policy that will continue to dampen growth until we see an increase in unemployment and further demand disruption. A broad-based slowdown in the economy, coupled with current rate environment, will cause some stress for borrowers. This highlights the importance of why we are focused on business models with high variable cost structures and with those that have pricing power.

82% of our portfolio by fair value was comprised of software and business services companies at quarter end and are generally characterized by high levels of recurring revenue, predictable cash flows, variable cost structures and pricing power. Our portfolio has shown resiliency to date, and we believe the underlying business models of our bars are robust and durable. However, we believe economic cycles do exist. As such, we will continue to focus on staying on top of the capital structure and operate in middle of our target leverage range. With that, I’ll pass it over to Bo discuss this quarter’s investment activity.

Bo Stanley: Thanks, Josh. I’d like to start by laying on some additional thoughts on the direct lending environment, and then more specifically, how it relates to the positioning of our portfolio in a way we’re thinking about current opportunities in the market. 2022 was a year that underscored the value proposition of private credit for borrowers. New issued leverage loan volume reached a 12-year low and was down 63% from 2021 as public credit markets were largely unavailable. As a result, private credit providers stepped in as a main source of financing solutions, given the ability to provide speed and certainty of execution despite instability in the broader markets. One of the main themes over the last few quarters has been the growing market share of direct lenders and the large syndicated sponsor financings.

Direct lenders, with the ability to write sizable checks, are benefiting from the opportunity to participate in larger transactions, which otherwise would have been financed in the broadly syndicated loan market. Notably, these investment opportunities present attractive risk reward dynamics as deal terms have moved in a more lender-friendly direction, indicated by wider spreads, tighter documents and lower leverage. We believe this shift in the underwriting terms reflects the appropriate compensation to lenders given the uncertain environment we’re investing in today. We are well positioned to take advantage of this opportunity in the market, given our ability to invest – alongside affiliated Sixth Street companies. As capital has generally become more constrained, the power of the Sixth Street platform has allowed us to finance larger, more established companies, while remaining selective.

We believe this creates a competitive advantage in today’s investing environment as the number of direct lenders willing and able to participate in larger transactions is limited. In addition to the strong originations activity supporting this opportunity in the market in Q4, we have a robust pipeline for the first half of 2023, including several large financings that have already been publicly announced. As we have the ability to co-invest with Sixth Street affiliated funds on these transactions, we have flexibility to determine the optimal final hold sizes for our balance sheet. Turning now to our investment activity for the quarter, Q4 was productive, with total commitments of $241 million and total fundings of $212 million across seven new portfolio companies and upsizes to five existing investments.

We experienced $282 million of repayments from seven full and three partial investment realizations. The increase in repayment activity was largely driven by idiosyncratic payoffs of our two largest investments by fair value as of 9/30 that we discussed on our last earnings call, violating the front line, which represented 58% of repayments for the quarter. For the full year of 2022, we provided $1.1 billion of commitments and closed $864 million of fundings. Total repayments were $654 million for the year, resulting in net portfolio growth of $210 million. Year-over-year, our portfolio grew by 11%, which reflects our deliberate effort to grow responsibly. We were able to remain selective in the investments that we make, given the size of our capital base, but not require us to be asset gatherers, but rather bottoms up fundamental investors and focus on driving return on capital for our investors.

82% of total commitments this year were sponsored transactions within our specialized sector sub-teams. We continue to execute on our software and business services themes, where we believe we have a competitive advantage and where the underlying companies have attractive revenue characteristics, high-quality customer bases and robust business models. At December 31, our top industry exposure by fair value was to business services at 14.4%. We’d like to take a moment to provide an update on one of our retail ABL investments that has recently been in the press, Bed Bath & Beyond. As mentioned during our Q3, 2022 earnings call, we had aged a FILO term loan commitment in September of 2022 to support the operational turnaround by the company and provide additional liquidity.

As a result of this transaction, we hold a $55 million paramount commitment as of 12/31 of the FILO term loan, which represents less than 2% of our total assets as of year-end. On February 6, the company announced it was raising up to $1.025 billion of new equity capital through a public offering. This offering allows the company to avoid bankruptcy found in the near term, which is a positive for all the company’s stakeholders, including employees. Along with the capital raise, Sixth Street made an additional investment in a more senior position in the capital structure. Our position, which is already underwritten to liquidation value, is improved as a result of the new capital raise and our more senior position in the capital structure. Obviously, this remains an ongoing situation that at this moment, we feel good about the security.

Our retail ABL capabilities have been a distinguishing feature of our investment strategy since we began the company back in 2011. We have executed over 25 transactions and invested over $1 billion of capital through TSLX. On these investments, we have taken 9 through the bankruptcy process without any losses. From a performance perspective, gross unlevered return on fully realized retail ABL investments is 20.8% as of 12/31. We have a core competency in managing these types of investments, and we’ll look to continue to execute on this strategy through the same playbook we established years ago. Moving on to the repayment side, one realization that we’d like to highlight is our investment in TherapeuticsMD, which demonstrates the positive impact of proactive asset management for our shareholders.

Since our initial investment in 2019, the company faced multiple challenges, including impacts from COVID-19, resulting in underperformance relative to expectations. As the situation evolves, Sixth Street worked with the company as advisers toward a path asset, including multiple amendments and a large partial paydown prior to our exit. In December 2022, Sixth Street’s debt was fully repaid when the company licensed full commercial rights of its products. TXMD will continue to be a public company receiving milestone payments and 20 years of royalties on sales. Through active portfolio management and extensive experience in the healthcare space, TSLX generated approximately 15.5% IRR and 1.4x MOM on the investment with a beneficial outcome for both parties.

From a portfolio yield perspective, our weighted average yield on debt and income-producing securities at amortized cost increased to 13.4% from 12.2% quarter-over-quarter. The increase primarily reflects a rise in the weighted average reference rate reset of 115 basis points over the quarter. The weighted average yield at amortized cost on new investments, including upsizes for Q4, was 12.6% compared to a yield of 11.9% on exited investments. Looking at the year-over-year trends, our weighted average yield on debt and income producing securities at amortized cost is up about 320 basis points from a year ago. The significant increase in our yields in 2022 illustrates a, positive asset sensitivity for our business from increased base rates beyond our floors in addition to our selective origination approach across themes and sectors.

Moving on to the portfolio composition and credit stats across our core borrowers for whom these metrics are relevant. We continue to have conservative weighted average attach and detach points of 0.9 times and 4.5 times respectively. And weighted average interest coverage decreased from 2.6x to 2.2x. The decrease in interest coverage is in line with our expectations from the impact of rising rates on the cost of funds for our borrowers. Our interest coverage metric assumes we apply reference rates as at the end of the year to the run rate borrower EBITDA, we believe this is a better representation of our position of our borrowers as opposed to a look back metric, such as LTM. One additional nuance, we’d like to highlight on interest coverage relates to the positioning of our portfolio towards software and business services.

These businesses generally see more limited fixed charge requirements, such as capital expenditures. Other more capital-intensive industries experienced higher fixed charges in addition to financing costs, meaning interest coverage metrics likely understate fixed obligations of those businesses. As of Q4, 2022, the weighted average revenue and EBITDA of our core portfolio companies was $152 million and $46 million, respectively, representing an increase in both metrics from Q3. Finally, the performance rating of our portfolio continues to be strong, with a weighted average rating of 1.12 on a scale of one to five, with one being the strongest, representing no change from last quarter’s ratings. We continue to have minimal non-accruals with only one portfolio company on non-accrual representing less than 0.01% of the portfolio at fair value and no new names added to non-accrual during Q4.

With that, I’d like to turn it over to Ian to cover our financial performance in more detail.

Ian Simmonds: Thank you, Bo. We finished the year with a strong quarter from an earnings and investment activity perspective. In Q4, we generated net investment income per share of $0.65, resulting in full year net investment income per share of $2.13. Our Q4, net income per share was $0.57, resulting in full year net income per share of $1.38. There was $0.11 per share unwind of previously accrued capital gains incentive fees in 2022, which is a non-cash reversal. Excluding the $0.11 per share unwind for this year, our adjusted net investment income and adjusted net income per share for the year were $2.01 and $1.27, respectively. At year-end, we had total investments of $2.8 billion, total principal debt outstanding of $1.5 billion and net assets of $1.3 billion or $16.48 per share, which is prior to the impact of the supplemental dividend that was declared yesterday.

Our ending debt-to-equity ratio was 1.13x, down from 1.16x in the prior quarter, and our average debt-to-equity ratio also decreased slightly from 1.15x to 1.14x quarter-over-quarter. For full year 2022, our average debt-to-equity ratio was 1.03x up from 1x in 2021 and well within our previously stated target range of 0.9 to 1.25x. Our liquidity position remains robust with $866 million of unfunded revolver capacity at year-end against $178 million of unfunded portfolio company commitments eligible to be drawn. Our year-end funding mix was represented by a 53% unsecured debt. Post quarter end, we satisfied the maturity of our $150 million January 2023 unsecured notes through utilization of undrawn capacity on our revolving credit facility. The settlement marginally decreased our weighted average cost of debt and had no impact on leverage.

Moving to our presentation materials. Slide 10 contains this quarter’s NAV bridge. Walking through the main drivers of NAV growth, we added $0.64 per share from adjusted net investment income against our base dividend of $0.45 per share. There was $0.11 per share reduction to NAV as we reversed net unrealized gains on the balance sheet related to investment realizations and recognized these gains into this quarter’s income. The reversal of unrealized gains this quarter was primarily driven by the early payoff of Biohaven, which resulted in an unwinded $0.12 per share from unrealized gains to net investment income for the quarter. There were minor positive impacts from changes in credit spreads on the valuation of our portfolio and a positive $0.01 per share impact from portfolio company-specific events.

Pivoting to our operating results detailed on Slide 12, we generated a record level of total investment income for the quarter of $100.1 million, up 29% compared to $77.8 million in the prior quarter. The increase was driven by a rise in the contractual interest income earnings power of the business, as well as other income related to the Biohaven payoff specifically. Walking through the components of income. Interest and dividend income was $85.8 million, up 15% from the prior quarter. Other fees representing prepayment fees and accelerated amortization of upfront fees from unscheduled pay down, were $11 million, up from $429,000 in the prior quarter due to higher portfolio repayment activity. Other income was $3.4 million, up from $2.7 million in the prior quarter.

Net expenses, excluding the impact of noncash reversal related to unwind of capital gains incentive fees, were $47.5 million, up from $40.3 million in the prior quarter. This was primarily due to the upward movement in reference rates, which increased our weighted average interest rate on average debt outstanding from 4.3% to 5.6% and higher incentive fees as a result of this quarter’s over earning. During 2022, base rates increased by approximately 425 basis points. And the impact on earnings became evident in the back half of the year given lag in reference rate resets for borrowers. Given the low financial leverage embedded in BDCs, asset sensitivity has a larger impact than liability sensitivity and proved to be a tailwind for our business as we saw increased asset level yields drive return on equity.

For a year characterized by spread income, the rise in interest rates and wider spreads resulted in the business exceeding the upper end of our beginning year ROE adjusted net investment income target of 11.5% or $1.92 per share for 2022. Net unrealized losses, largely from the impact of spread widening experienced in Q2 on portfolio marks, had a significant impact on our net income for the year, which we expect to unwind as credit spreads tighten or investments are paid off. Based on our expectations for our net asset level yields, the movement in reference rates, cost of funds and financial leverage, we expect to target a return on equity for 2023 of 13% to 13.2%. Using our year-end book value per share of $6.39, which is adjusted to include the impact of our Q4 supplemental dividend, this corresponds to a range of $2.13 to $2.17 for full year 2023 adjusted net investment income per share.

As we said, we expect to over earn our $1.84 per share annualized base dividend in the near term, and we’ll continue to distribute overearnings to shareholders through our supplemental dividend framework. With that, I’d like to turn it back to Josh for concluding remarks.

Joshua Easterly: Thank you, Ian. We believe we are transitioning from an era of easy money to a new macro super cycle that we believe will magnify volatility relative to recent history. With such volatility, we’ll come to spurge and returns and will elevate the importance of management’s capabilities and skills. The ironies, however, even in low volatility and low rate environment, returned this version has already existed. Now we can only expect it to increase. Our rates for the foreseeable future will most definitely cause stress for certain borrowers, followed by an uptick in defaults from the historical low levels we’ve experienced more recently. That being said, we anticipate credit issues to be heavily related to borrowers with weaker underlying business models, and we are confident in the durability of our portfolio companies.

We believe our track record over the past 12 years since inception, supports our ability to continue to generate industry-leading returns for our shareholders. We have generated an annualized return on equity on net income since our March 2014 IPO of 13.1%. We attribute a large portion of our success that our shareholders have enjoyed to ability to over earn our cost of capital by avoiding credit losses and appropriately pricing spreads on investments that take into account the cost embedded in operating our business. We remain constructive on the opportunity set ahead of us. We continue to experience elevated all-in yields on our assets, and we expect credit costs to remain low given our investment selection discipline and the health of our existing portfolio.

We began the year with significant liquidity and capacity to drive incremental ROEs, and are optimistic about opportunities to enhance our capital structure through the course of the year. With that, thank you for your time today. Operator, please open the line for questions.

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Q&A Session

Operator: Our first question comes from the line of Mark Hughes with Truist. Your line is open. Please go ahead.

Joshua Easterly: Hi, Mark.

Operator: Mark, your phone might be on mute.

Mark Hughes: Yes, my phone is on mute. I’m so sorry. Good morning.

Joshua Easterly: Good morning, Mark.

Mark Hughes: My question was, how are you thinking about fees — fee revenue in 2023? You’ve given some good guidance on NII. Just curious what you think the fee environment is going to be like.

Joshua Easterly: Yes, it’s a good question, Mark. It’s really hard to tell because it’s a function of kind of repayment velocity. But to just give you some numbers, in 2000, when we think about fees, if we think about it and basically I would say two categories or three categories, which is accelerated OID, prepayment fees and amendment fees and other income. That’s historically been — I think, in 2022, those fees were, let’s do the math, about $0.37 per share. In 2021, those fees were 47 – about $0.54, $0.56 per share. In 2023, we actually – in our guidance numbers, they’re significantly below those levels, and we anticipate to be significantly below those levels that are embedded in our guidance. So in our guidance numbers, they are about $0.22 per share. So that’s heavily weighted towards, again, another year of spread income. If you see velocity in the book, obviously, it’s going to be much, much higher, but it’s significantly below ’22 levels and ’21 levels.

Mark Hughes: Yes. No, I appreciate the specifics there. And then when you look at the curve, talked about keeping the base dividend at the $0.46 informed by your lookout to 2025. How much cushion, just generally speaking, would you — do you still have over the dividend over those next couple of years?

Joshua Easterly: Yes. Significant — look, I think we just went through the math on 2023, which 2023 has, again, is mostly spread income our per share guidance is —

Ian Simmonds: 2013.

Joshua Easterly: 2013 and 2017. The base dividend level is?

Ian Simmonds: A $1.84.

Joshua Easterly: $1.84. So there’s really a lot of cushion. In 2024, similarly, again, we don’t really model significant level. We think about upside in fee income as kind of be an upside to our guidance. So in 2024, those levels of fee income are basically the same. And again, our base dividend is $1.84 and we think we’re significantly above that as well. So we knew we’re going to over for the next couple of years, but we don’t want to put ourselves in a position where we would have to cut the dividend. And so we set dividend where we see a significant cushion in the next couple of years. We were just looking at the curve.

Mark Hughes: Thank you very much.

Operator: Thank you. And one moment for our next question. Our next question comes from the line of Finian O’Shea with Wells Fargo. Your line is open. Please go ahead.

Finian O’Shea: Hi, everybody. Good morning. A question on the large club deals. It looks like we have one this quarter with Avalara not signaling in on that name. But I don’t think those are too typical for you to partake in. Can you talk about the threshold for what makes that kind of deal compelling? Is it company quality or terms as to why you so seldom invest in those? And then on the downside, perhaps, can you talk about structural elements you do give up? How much less control you might have and so forth? Thank you.

Joshua Easterly: First all, good morning Fin. I hope you’re doing well this point. So look, we’ve talked a lot about this. On the upper middle market and that large cap space has significantly changed given the environment we’re in. And so pre-12 months ago, obviously, we thought was competitive and offered little relative value compared to the broadly syndicated market, that’s completely changed. Quite frankly, that upmarket we find that the marginal capital fuels are able to drive better terms and you can finance larger companies that are at scale. So as I think people know, we’ve been involved in most of those deals that have been announced including Emerson, which is as yet to close, which we’ve led, is yet to close, which we’ve led and other ones.

So we find there’s a lot of value. The — and that the marginal capital is able to drive pricing and structural enhancements — and so — and then obviously, given the macro, you’re financing those businesses in an environment where you are — you have a low rate environment and kind of a known growth environment compared to historically. So we like the value that’s being offered in that market. The trade-off is that they’re clubs and you got to see that you’re at likeminded people and if that document works, and we think it does. So Bo, anything to add there?