Falling Base Rates And Tight Spreads Will Pressure Returns And Limit Upside

Catalysts

About Sixth Street Specialty Lending

Sixth Street Specialty Lending provides direct lending and structured credit solutions to middle market and large corporate borrowers through a differentiated, thematically sourced portfolio.

What are the underlying business or industry changes driving this perspective?

• Persistent oversupply of capital in private credit and record tight spreads in broadly syndicated loans are likely to cap future asset yields, pressuring revenue growth and limiting upside to net investment income as higher coupon legacy assets refinance out.
• Elevated early repayments and refinancings into lower spread private and public markets, which recently generated outsized activity based fees, may normalize to historical levels, reducing fee income tailwinds and weighing on earnings stability.
• Continued flow of borrowers back to public credit markets, helped by structurally lower syndicated loan spreads, could reduce the volume and pricing power of off the run direct lending opportunities, constraining portfolio growth and compressing net margins.
• Industry wide pressure on BDC valuations and constrained equity issuance capacity, particularly for nontraded vehicles, may slow scalable balance sheet growth just as asset level yields drift lower, tempering long term earnings per share expansion.
• A falling base rate environment combined with an entirely floating rate liability structure and tightening spreads on new originations could narrow the spread between asset yields and funding costs, gradually eroding return on equity and net income growth.

Assumptions

How have these above catalysts been quantified?

• Analysts are assuming Sixth Street Specialty Lending's revenue will decrease by 5.9% annually over the next 3 years.
• Analysts assume that profit margins will increase from 41.2% today to 48.6% in 3 years time.
• Analysts expect earnings to reach $188.2 million (and earnings per share of $1.91) by about December 2028, down from $191.5 million today. The analysts are largely in agreement about this estimate.
• In order for the above numbers to justify the price target of the analysts, the company would need to trade at a PE ratio of 16.5x on those 2028 earnings, up from 10.8x today. This future PE is lower than the current PE for the US Capital Markets industry at 23.8x.
• Analysts expect the number of shares outstanding to grow by 0.89% per year for the next 3 years.
• To value all of this in today's terms, we will use a discount rate of 10.39%, as per the Simply Wall St company report.

Risks

What could happen that would invalidate this narrative?

• If credit issues truly are behind the broader BDC sector and the market has overreacted to recent volatility, sentiment toward BDCs could normalize over time and re-rate the group upward. This could lift Sixth Street Specialty Lending's valuation multiple and share price as earnings and net asset value remain resilient, supporting higher earnings and return on equity.
• The platform's demonstrated ability to win large, thematically sourced off the run deals such as Walgreens and Velocity Clinical Research, supported by deep sector teams and a long track record in areas like retail ABL and healthcare, could sustain above sector spreads. This could generate alpha and drive higher net investment income and net margins than the market currently discounts.
• Sixth Street Specialty Lending's long history in structured credit and CLO liabilities, with strong realized returns and the flexibility to rotate capital as relative value shifts, may allow it to keep deploying at attractive risk adjusted spreads even in a tighter lending environment. This could support long term revenue and earnings growth rather than flat performance.
• The company’s conservative credit metrics, low nonaccrual levels and disciplined capital allocation including only issuing equity when accretive, combined with a large liquidity buffer and no near term debt maturities, could allow it to defend or gradually increase the dividend. This could reinforce investor demand and support both net asset value per share and earnings stability.
• If the industry wide constraint on new capital for direct lending and nontraded BDCs plays out as management expects, competitive pressure could ease over time, preserving spreads on new originations and enabling Sixth Street Specialty Lending to maintain or expand net interest margins and long term earnings power.

Valuation

How have all the factors above been brought together to estimate a fair value?

• The analysts have a consensus price target of $23.75 for Sixth Street Specialty Lending based on their expectations of its future earnings growth, profit margins and other risk factors.
  
• In order for you to agree with the analysts, you'd need to believe that by 2028, revenues will be $387.4 million, earnings will come to $188.2 million, and it would be trading on a PE ratio of 16.5x, assuming you use a discount rate of 10.4%.
  
• Given the current share price of $21.83, the analyst price target of $23.75 is 8.1% higher. The relatively low difference between the current share price and the analyst consensus price target indicates that they believe on average, the company is fairly priced.
  
• We always encourage you to reach your own conclusions though. So sense check these analyst numbers against your own assumptions and expectations based on your understanding of the business and what you believe is probable.