TSLX Q2 2024: Passes on sub-450bp deals amid Europe growth push
- Disciplined Investment Selection: Management remains highly selective, passing on deals that do not meet their stringent spread and risk‐return criteria. This focus on investing only in opportunities that exceed their cost of equity supports superior return on equity and long‐term shareholder value.
- Expanding European Platform: The team highlighted a growing European presence with attractive risk‐return profiles relative to U.S. opportunities, which not only diversifies the portfolio but also positions the firm to capitalize on better pricing dynamics overseas.
- Fee-Driven Income from Natural Turnover: Natural portfolio turnover, including increased repayment activity and related activity-based fees, is expected to bolster recurring revenue sources, thereby supporting net investment income and reinforcing the company’s economic model.
- Tightening spreads and yield pressures: Executives noted that many potential deals are being passed on because their spreads—at times around 450 basis points or lower—do not adequately cover the required cost of equity. This environment could limit attractive investment opportunities and pressure future margins.
- Tail risks from legacy portfolio vintages: Management indicated that while new investments are performing well, earlier vintages may exhibit “tails” where operating returns diverge from GAAP returns. This suggests that underperformance in older investments could weigh on overall portfolio performance.
- Challenges in sourcing and executing complex, non-sponsored deals: The discussion highlighted that non-sponsored deals require more intensive diligence and longer execution timelines. This complexity could hinder efficient capital deployment and slow the generation of fee-based income, adding operational risk.
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Deal Economics
Q: Deals passed failing required spreads?
A: Management emphasized they pass on deals where the spreads fall below their required cost-of-equity threshold, not due to credit deterioration, ensuring shareholder returns remain robust. -
Macro Outlook
Q: What's your macro outlook for next year?
A: They remain constructive, expecting the Fed to pivot with potential rate cuts and improved conditions supporting stable operating earnings. -
Portfolio Turnover
Q: Impact of turnover on portfolio returns?
A: Turnover has been light post-rate hikes, but natural rotation is anticipated to generate increased activity-based fees, benefiting shareholders over time. -
Credit Cycle
Q: Will lower rates trigger a deep credit cycle?
A: Management does not foresee a deep credit cycle; current fundamentals and elevated tails suggest that while mistakes exist, the overall balance remains robust. -
Funding Balance
Q: Do repayments offset new originations?
A: They expect a near net-flat outcome as increased repayments are balanced by new deployments, keeping the portfolio’s growth stable. -
Spreads Dynamics
Q: Are spread tightenings driven by supply?
A: Management noted spread tightening stems from an oversupply of private capital, with future demand likely to restore equilibrium. -
Deal Flow Change
Q: Has the rate of deal flow changed?
A: While the head rate appears slightly lower, overall hit rates remain steady due to a disciplined, selective investment approach. -
European Footprint
Q: How is the European deal activity?
A: The platform in Europe is growing in number, offering attractive risk-return profiles despite representing smaller dollar volumes. -
Average Commitment
Q: Are smaller deals increasingly common?
A: A lower average commitment is observed due to co-investment strategies, though core positions remain in the tens of millions. -
Pipeline Spreads
Q: Is the pipeline spread improvement market-driven?
A: Improved spreads in the pipeline reflect both favorable market conditions and intentional strategic shifts toward nonsponsor deals. -
Regulatory Risk
Q: Will private credit face tougher regulation?
A: They believe private credit carries lower systemic risk than banks, making significant regulatory impacts unlikely. -
Lithium Headwinds
Q: Concern over lithium sector headwinds?
A: Issues at Lithium Technologies are viewed as isolated events, not indicative of broader sector weaknesses. -
Documentation Terms
Q: Have deal documentation terms changed?
A: Underwriting standards and documentation terms have remained stable, indicating consistent credit quality. -
Complex Deals Timing
Q: When might complex deals pick up?
A: Future complex opportunities are expected to arise as M&A activity increases, driven by accumulated tails from prior misallocations. -
Sponsor Concentration
Q: Is there increased sponsor concentration risk?
A: The portfolio is well diversified, with no single sponsor exceeding 10%, mitigating concentration concerns. -
Pipeline Sizing
Q: How sizable is the near-term pipeline?
A: The near-term pipeline is estimated at a couple of hundred million dollars, supporting modest incremental growth. -
Nonsponsor Diligence
Q: Do nonsponsor deals take longer to close?
A: Nonsponsor deals typically require more time and resources due to intensive diligence, yet they ultimately offer higher risk-adjusted returns. -
Additional Growth
Q: Will further growth depend on sponsor deals?
A: Growth will be driven by a mix of strategies, with sponsor deals complementing other sectors to support overall return on equity.
Research analysts covering Sixth Street Specialty Lending.