Fitch Ratings has affirmed Sixth Street Specialty Lending, Inc.'s (TSLX) Long-Term Issuer Default Rating (IDR), secured debt rating and unsecured debt rating at 'BBB'.

The Rating Outlook is Stable.

Today's rating actions have been taken as part of a broader review of business development companies (BDCs), which included 18 publicly rated firms. For more information on the peer review, please see 'Fitch Ratings Completes 2023 BDC Peer Review,' available at www.fitchratings.com.

Key Rating Drivers

The rating affirmations reflect TSLX's strong credit performance, consistent operating performance, strong management team, focus on first lien investments with lower underlying portfolio company leverage and meaningful call protection, solid asset coverage cushion, strong liquidity, consistent dividend coverage and access to investment resources from Sixth Street Partners, LLC.

Rating constraints include above-average industry concentrations in TSLX's portfolio given the meaningful exposure to software businesses and the recent decline in the unsecured funding mix. Rating constraints for BDCs more broadly include the market impact on leverage, given the need to fair-value the portfolio quarterly, dependence on access to the capital markets to fund growth and a limited ability to retain capital due to distribution requirements. Additionally, Fitch believes BDCs will experience weaker asset quality metrics in 2023 amid higher interest rates and slower growth at portfolio companies.

TSLX's asset quality trends have been strong since inception as demonstrated by the generation of cumulative net realized gains through Dec. 31, 2022, including $16.7 million in 2022. Non-accrual investments were below-average at YE22, amounting to 0.1% of TSLX's debt portfolio at cost and less than 0.1% at fair value. Fitch expects non-accruals will tick up in 2023 given higher debt service burdens for borrowers but believes TSLX's credit performance will remain above-average given its first lien focus (90.3% of the portfolio at fair value at YE22) and low non-accruals.

TSLX's net investment income (NII), adjusted for non-cash capital gain incentive fee accruals, amounted to 6.0% of the average portfolio at cost in 2022, which was down from 6.6% in 2021 but remained above-average. Fitch believes TSLX's core earnings will benefit from higher interest rates in 2023, albeit to a lesser degree than peers since the firm effectively swaps all of its fixed-rate debt to floating-rate. Fitch views TSLX's approach to managing interest rate risk favorably, as it should continue to support more consistent earnings and dividend coverage metrics over time.

TSLX's leverage (par debt-to equity), was 1.13x at YE22, which was up from 0.95x at YE21 but modestly below-average and within the firm's targeted range of 0.9x-1.25x. The leverage ratio at YE22 implied an asset coverage cushion of 20.4%, which was within Fitch's 'bbb' category benchmark range of 11%-33%. Fitch expects TSLX will continue to maintain the asset coverage cushion at an appropriate level to account for potential valuation volatility and/or future credit losses. Fitch believes TSLX could be at a competitive advantage for new origination opportunities since the firm has incremental capacity to the high-end of its targeted leverage range and its stock price has generally traded at a premium to its net asset value, allowing TSLX to issue equity for growth capital.

Unsecured debt accounted for 52.3% of total debt outstanding at YE22, which was down from 73.9% at YE21 as the firm increased borrowings under its secured credit facility to fund portfolio growth. Pro forma for the refinancing of $150 million of unsecured notes that matured January 2023 with secured borrowings, unsecured debt declined to 42.7% of total debt, which is within Fitch's 'bbb' category benchmark range of 35%-50%. While this ratio could tick down further in the near term if TSLX funds additional portfolio growth with secured borrowings amid more challenging capital markets conditions, Fitch expects that the company will continue to opportunistically access the unsecured markets over time. TSLX's next unsecured debt maturity is in November 2024, when $347.5 million of notes come due.

TSLX's liquidity profile is strong, with $10.2 million of unrestricted cash and $865.7 million of availability under its revolving credit facility at YE22. Liquidity was more than sufficient to fund TSLX's unfunded commitments to portfolio companies, which totaled $338 million at YE22, of which only $178 million was eligible to drawn.

Fitch views TSLX's dividend policy, which provides for a base dividend and a supplemental dividend, favorably as it helps ensure sufficient dividend coverage in periods when earnings are pressured. NII coverage of regular (excluding supplemental) dividends declared amounted to 118.5% in 2022. Adjusting for non-cash income and expenses, TSLX's cash earnings coverage of regular dividends declared was lower at 99% but would improve meaningfully to 122% if adjusted for participation in the dividend reinvestment plan. Paid-in kind income represented 4.3% of interest and dividend income in 2022, which was below-average.

The Stable Outlook reflects Fitch's expectations for continued operating consistency, a continued focus on first lien investments, and the maintenance of strong asset quality, ample liquidity, solid dividend coverage and leverage within the targeted range.

Rating Sensitivities

Factors that could, individually or collectively, lead to negative rating action/downgrade:

An increase in leverage that is not commensurate with the risk profile of the portfolio; an inability to maintain sufficient cushion to asset coverage to account for valuation volatility; a sustained meaningful increase in non-accrual levels; meaningful realized losses; deterioration in the portfolio risk profile as demonstrated by a meaningful decline in exposure to first lien investments, meaningful up-ticks in underlying portfolio leverage and/or a meaningful deterioration in portfolio company interest coverage or covenants which signal the potential for future asset quality issues; a sustained decline in unsecured debt-to-total debt below 40% and/or weaker cash income dividend coverage could all yield negative rating momentum.

Factors that could, individually or collectively, lead to positive rating action/upgrade:

Very strong and differentiated asset quality performance of recent vintages, which will be evaluated in combination with the stability and consistency of TSLX's operating performance, asset quality, valuation, and underlying portfolio metrics, including leverage and interest coverage could yield positive rating momentum. An increase in unsecured debt to at least 50% of total debt, the maintenance of ample liquidity, and consistent core operating performance would also be necessary to yield positive rating action. Although not envisioned, a reduction in the leverage target which was not accompanied by an offsetting increase in the portfolio risk profile could also contribute to positive rating momentum.

DEBT AND OTHER INSTRUMENT RATINGS: KEY RATING DRIVERS

The alignment of the unsecured debt rating and secured debt rating with that of the Long-Term IDR reflects solid collateral coverage for all classes of debt given TSLX is subject to a 150% regulatory asset coverage requirement and has a meaningful unsecured funding component.

DEBT AND OTHER INSTRUMENT RATINGS: RATING SENSITIVITIES

The secured and unsecured debt ratings are primarily linked to the Long-Term IDR and are expected to move in tandem. However, a reduction in unsecured debt as a proportion of total debt could result in the unsecured debt rating being notched down from the IDR.

Best/Worst Case Rating Scenario

International scale credit ratings of Financial Institutions and Covered Bond issuers have a best-case rating upgrade scenario (defined as the 99th percentile of rating transitions, measured in a positive direction) of three notches over a three-year rating horizon; and a worst-case rating downgrade scenario (defined as the 99th percentile of rating transitions, measured in a negative direction) of four notches over three years. The complete span of best- and worst-case scenario credit ratings for all rating categories ranges from 'AAA' to 'D'. Best- and worst-case scenario credit ratings are based on historical performance. For more information about the methodology used to determine sector-specific best- and worst-case scenario credit ratings, visit https://www.fitchratings.com/site/re/10111579

REFERENCES FOR SUBSTANTIALLY MATERIAL SOURCE CITED AS KEY DRIVER OF RATING

The principal sources of information used in the analysis are described in the Applicable Criteria.

ESG Considerations

Unless otherwise disclosed in this section, the highest level of ESG credit relevance is a score of '3'. This means ESG issues are credit-neutral or have only a minimal credit impact on the entity, either due to their nature or the way in which they are being managed by the entity. For more information on Fitch's ESG Relevance Scores, visit www.fitchratings.com/esg.

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