Sixth Street Specialty Lending (TSLX) delivered a strong Q1 2024, reaffirming its position as a standout performer in the BDC sector. But buried within the transcript, amidst discussions of peak earnings and a “growing tail” of credit risk, lies a subtle yet significant shift in strategy that seems to have flown under the radar: TSLX is quietly harnessing its vast liquidity to strategically pre-fund liabilities, creating an “invisible lever” poised to amplify returns in a declining rate environment.

While the market obsesses over spread compression and the looming specter of credit losses, TSLX is playing a different game. They recognize that the BDC sector, heavily reliant on floating rate assets, will face NII headwinds as rates fall. But TSLX, rather than succumbing to the inevitable decline, is building a fortress of liquidity, strategically deploying it to pre-fund future debt maturities and effectively lock in a lower cost of capital.

The most striking example of this maneuver is the pre-funding of the $347.5 million of 2024 notes due in November. By reserving for this repayment under their revolving credit facility, TSLX essentially swaps higher-cost unsecured debt for lower-cost secured debt, creating an immediate economic benefit that will materialize in 2025. This is akin to refinancing a mortgage at a lower rate, but with the added twist of doing it *before* rates actually decline.

This pre-funding strategy is not a one-off tactic. TSLX has consistently employed this approach, carefully managing their debt maturity profile to ensure a weighted average duration on liabilities that "meaningfully exceeds" the weighted average life of their assets funded by debt. This asset-liability matching principle, a cornerstone of TSLX's risk management philosophy, creates an "invisible lever" that will amplify returns as rates fall.

Understanding the "Invisible Lever"

To understand the power of this strategy, consider a hypothetical scenario where base rates decline by 100 basis points in 2025. A typical BDC, heavily reliant on floating rate liabilities, would see its NII erode by approximately $0.12 per share on an annualized basis (based on TSLX's estimate of a $0.03 per share decline for every 25 basis points). However, TSLX, having pre-funded a significant portion of its higher-cost debt, would experience a much smaller decline in NII, potentially outperforming its peers by a considerable margin.

This "invisible lever" effect becomes even more pronounced as rates continue to fall. With each decline, TSLX's pre-funded liabilities become increasingly valuable, further insulating their earnings from rate volatility. This creates a powerful dynamic that is likely to drive outperformance relative to the sector in a declining rate environment.

TSLX's Access to Equity Capital

The key to TSLX's success lies not only in their strategic use of liquidity but also in their ability to access it in the first place. Unlike many of their peers, who struggled to raise capital during the market turmoil of 2023, TSLX capitalized on their strong stock performance and reputation for disciplined underwriting, issuing equity above net asset value and deploying the proceeds into attractive, higher-yielding investments.

This ability to access equity capital in a volatile market is a testament to TSLX's track record of consistently growing net asset value, representing a 3.5% annualized growth rate before special and supplemental dividends since inception. This disciplined approach to capital allocation has earned them the trust of investors, granting them access to the capital needed to execute their pre-funding strategy.

Estimated ROE in a Declining Rate Environment

To illustrate the potential impact of this strategy, let's compare TSLX's estimated ROE in a declining rate environment to the average ROE of their peers over the last two years. As Josh Easterly, CEO of TSLX, mentioned, TSLX generated an average annualized ROE of approximately 12% on adjusted net income for fiscal years 2022 and 2023, nearly double that of their peers, who generated a two-year average ROE of 6.5% on net income through September 30, 2023.

Now, let's assume a scenario where base rates decline by 100 basis points in 2025, and spreads remain constant. Based on TSLX's estimate of a $0.03 per share decline in NII for every 25 basis point decline in base rates, their adjusted net investment income would decline by $0.12 per share. Assuming their balance sheet remains constant, this would translate to an estimated ROE of approximately 11.5% in 2025.

In contrast, assuming their peers also experience a similar decline in NII due to falling rates, their estimated ROE would fall to approximately 5%. This illustrates the potential for TSLX's pre-funding strategy to significantly outperform the sector in a declining rate environment, even as their own earnings power moderates.

TSLX's "Invisible Lever" in Action

This subtle yet significant shift in strategy is not a headline-grabbing announcement. It is a calculated maneuver, carefully executed over time, and designed to capitalize on a macroeconomic environment that many in the BDC sector are bracing for. As rates fall and competition intensifies, TSLX is quietly flipping the script, wielding an “invisible lever” that could transform the BDC landscape.

"Fun Fact: The term "Business Development Company" (BDC) was coined in the 1980s as part of the Small Business Investment Incentive Act, aimed at stimulating investment in small and mid-sized businesses. TSLX's innovative "invisible lever" strategy showcases the evolving nature of BDCs and their ability to adapt to changing market conditions."