Oaktree Specialty Lending Corporation (NASDAQ:OCSL) Q1 2023 Earnings Call Transcript

Oaktree Specialty Lending Corporation (NASDAQ:OCSL) Q1 2023 Earnings Call Transcript February 7, 2023

Operator: Welcome, and thank you for joining Oaktree Specialty Lending Corporation’s First Fiscal Quarter 2023 Conference Call. Today’s conference call is being recorded. At this time, all participants are in a listen-only mode, but will be prompted for a question-and-answer session following the prepared remarks. Now, I would like to introduce Michael Mosticchio, Head of Investor Relations, who will host today’s conference call. Mr. Mosticchio, please go ahead..

Michael Mosticchio: Thank you, operator, and welcome to Oaktree Specialty Lending Corporation’s first fiscal quarter conference call. Our earnings release, which we issued this morning, and the accompanying slide presentation can be accessed on the Investors section of our website at oaktreespecialtylending.com. Our speakers today are Armen Panossian, Chief Executive Officer and Chief Investment Officer; Matt Pendo, President; and Chris McKown, Chief Financial Officer and Treasurer. Also joining us on the call for the question-and-answer session is Matt Stewart, our Chief Operating Officer. Before we begin, I want to remind you that comments on today’s call include forward-looking statements reflecting our current views with respect to, among other things, the expected synergies and savings associated with the merger with Oaktree Strategic Income II, Inc., the ability to realize the anticipated benefits of the merger and our future operating results and financial performance.

Our actual results could differ materially from those implied or expressed in the forward-looking statements. Please refer to our SEC filings for a discussion of these factors in further detail. We undertake no duty to update or revise any forward-looking statements. I’d also like to remind you that nothing on this call constitutes an offer to sell or a solicitation of an offer to purchase any interest in any Oaktree fund. Investors and others should note that Oaktree Specialty Lending uses the Investors section of its corporate website to announce material information. The company encourages investors, the media and others to review the information that it shares on its website. With that, I would now like to turn the call over to Matt.

Matt Pendo: Thanks, Mike, and welcome, everyone. Thank you to all on the call for your interest in and support of OCSL. Prior to my remarks, I would like to note that all per share amounts that we reference on this call have been adjusted for the one for three reverse stock split that we implemented on January 23, 2023. Now turning to the results. We generated strong results in the fiscal first quarter as we identified compelling investment across sponsor and non-sponsor deals. This robust origination activity enabled us to further capitalize on higher base rates and spreads driving profitability. First quarter adjusted NII was $0.61 per share, a 10% increase from the $0.55 earned in the prior quarter. The increase was driven primarily by higher total investment income that more than offset increased interest expense.

Even as we grew, we remained highly selective maintaining our defensively positioned portfolio and strong credit quality. We again had no investments on non-accrual. We are mindful that in a rising rate environment, overall consumer spending and business investment tend to slow, creating the potential for a recession. As a result, we are proactively managing risks that may arise in our portfolio should the volatility persist. Given the strength of our earnings, our Board increased our quarterly dividend by 2% to $0.55 per share, this marked the 11th consecutive quarterly increase and our dividend is up more than 90% from its pre-pandemic level at the close of fiscal 2019. Looking more closely at our first quarter results, we reported NAV per share of $19.63, down from $20.38 for the prior quarter.

This decrease primarily reflected the $0.42 special distribution paid by OCSL during the quarter as well as unrealized depreciation related to price declines on certain public debt investments. In January, our portfolio experienced recovery in the prices of our core investments and our NAV as of January 31 was estimated to be up approximately 1% to $19.83 per share. Turning to the portfolio. We originated $250 million of new investment commitments in the first quarter more than double the level of the previous quarter. Of these 85% were first lien loans. The weighted average yield on new debt investments was 13.1%, which compares favorably to the 9.9% yield on new originations in the September quarter, as we were able to identify and capitalize on investment opportunities with wider spreads in the December quarter.

We received $104 million from paydowns, sales and exits in the first quarter, as we continue to selectively reinvest proceeds into better risk-adjusted opportunities. Importantly, the pipeline is very robust in the current quarter. We are drawing upon the breadth of the Oaktree platform to source attractive deals with strong downside protections. Looking ahead, we expect substantial benefits from our merger with Oaktree Strategic Income II, Inc., or OSI2, which we closed in January. Our combined company has more than $3.3 billion of assets on a pro forma basis resulting in an increase in first lien investment to 74%, creating greater scale and financial flexibility, while maintaining our value-driven investment strategy. We expect the merger to be accretive over the near and long term through cost savings, which we expect will total approximately $1.6 million of cost and operational synergies annually.

We also will benefit from reduced management fees for the next two years as Oaktree, our manager has agreed to waive $9 million of base management fees in total, $6 million in the first year and $3 million in the second. Since the closing of the merger, our trading liquidity has improved, and we have been making enhancements to our capital structure. Together, we are in excellent financial shape with strong liquidity and capital levels, and we are well positioned to continue delivering attractive returns to our shareholders. With that, I would like to turn the call over to Armen to provide more color on our portfolio activity and the market environment.

Armen Panossian : Thanks, Matt, and hello, everyone. I’ll begin with comments on the market environment. The US job market finished calendar 2022 in relatively strong shape with steady job growth. The economy also grew at an annual rate of 2.9% in the calendar fourth quarter. However, both measures marked slowdown from earlier months, likely reflecting the Federal Reserve’s aggressive rate actions. While futures markets anticipate additional rate increases at the next two Fed meetings, they are also betting that they will pause by late spring and before the end of the calendar year, begin to once again lower rates. The case for this dovish pivot appears driven by the expectation that US inflation will continue to decline at a fairly rapid rate.

However, while inflation in the US has slowed, China, the world’s second largest economy has fully reopened, which will likely boost global economic growth and may simultaneously exert upward pressure on global inflation this year, impacting prices in the US. Further, the US labor market continues to be historically tight with strong job growth and the lowest unemployment rate in more than 50 years. Still, recent figures show a mixed picture of US economic health, wage growth is leveling off and consumer spending is starting to ease, signaling that the US economy is slowing and could slide into recession. All of that noted, the uncertain economic backlog creates new opportunities for Oaktree. We have experienced across all market cycles and with a strong capital base and a long-term perspective, we have the conviction needed to withstand short-term volatility and continue to invest and generate strong returns for our shareholders.

While we will remain cautious moving forward, we are also confident in our team’s long history of identifying new investment opportunities, while maintaining solid credit quality. As you have heard me emphasize on previous calls, we focused on relative value in areas of the market where we can find the best risk-adjusted returns. We draw upon Oaktree’s scale and resources to invest across multiple areas, including the sponsor and non-sponsor backed markets, leveraging the firm’s ability to negotiate and structure customized deals that provide downside risk protection. Altogether, we are deploying capital on favorable terms to further build our portfolio and generate strong returns for our shareholders. Now turning to the overall portfolio. At the close of the first quarter, our portfolio was well diversified with $2.6 billion at fair value across 156 companies, up from 140 a year earlier.

86% of the portfolio was invested in senior secured loans, with first lien loans representing 72%, underscoring our emphasis on being at the top of the capital structure. We continue to emphasize larger, more diversified businesses that present lower risk, because they’re better equipped to navigate downturns. Overall, our borrowers have been navigating the current inflationary environment very well and have continued to experience steady performance despite the challenging market conditions. Median portfolio company EBITDA as of December 31 was approximately $128 million, generally in line with the prior quarter. Leverage in our portfolio of companies was relatively steady at 5.1 times, well below overall middle market leverage levels. The portfolio’s weighted average interest coverage declined slightly to 2.5 times as of December 31 from 2.7 times in the prior quarter due to rising base rates.

We leverage the Oaktree platform to originate $250 million of new investment commitments, of which $235 million was committed to new portfolio companies in the quarter. Let me share a few representative examples of our new investment activity. First, we originated a non-sponsored loan to Superior Industries, a public company that is a leading designer and manufacturer of aluminum wheels. It sells to original automobile and light truck equipment manufacturers, as well as aftermarket distributors in North America and Europe. The company holds a strong market share, maintains a low leverage profile and generates high free cash flow, supporting healthy margins. The deal consisted of a $400 million sole Oaktree commitment in a senior secured term loan that was used to refinance existing debt.

OCSL was allocated $40 million and the loan was attractively priced at SOFR plus 800. LATAM Airlines Group is another good example from our first quarter. It is a leading provider of passenger and cargo air transportation services throughout Latin America and it also applies to major destinations in North America and Europe. As you may recall, OCSL previously had an investment in LATAM as part of its restructuring in late 2020. The company came back to the market to refinance existing debt and raise additional working capital. A deal involved an Oaktree led $1.1 billion syndicated loan, of which Oaktree funded $750 million, priced at SOFR plus 9.5% with call protection and an 8.5% original issue discount. OCSL was allocated $26 million of the total loan.

Notably, we are also continuing to find opportunities in discounted CLO debt and ABS. Our CLO and ABS purchases totaled $20.7 million in the quarter with an average price of 87% of par. We see significant potential for upside should these return to par over time. In summary, our strong liquidity position, experienced across both periods of growth and contraction as well as the sourcing power of the Oaktree platform continue to put OCSL in excellent position for 2023. Now, I will turn the call over to Chris to discuss our financial results in more detail.

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Chris McKown: Thank you, Armen. OCSL delivered another quarter of strong financial performance beginning fiscal year 2023 with good momentum. For the first quarter, we reported adjusted net investment income of $37.1 million or $0.61 per share, up 10% from $33.7 million or $0.55 per share in the fourth quarter of fiscal year 2022. The increase was primarily driven by higher interest income resulting from rising base rates, partially offset by higher interest expense. Net expenses for the quarter totaled $40.3 million, up $6 million sequentially. The increase was mainly due to $5 million of higher interest expense as a result of the impact of rising interest rates on the company’s floating rate liabilities and modestly higher base management fees and Part I incentive fees due to the larger portfolio and its strong performance for the quarter.

Professional fees were up slightly due to seasonality. Turning to our credit quality, which continues to be excellent. As Matt mentioned, we had no investments on non-accrual at quarter end. With respect to interest rate sensitivity, OCSL still remains well situated to continue to benefit from a rising rate environment. As of December 31st, 87% of our debt portfolio at fair value was in floating rate investments. Our strong earnings in the first quarter were again due to the higher base rates, which in turn drove our interest income higher. We expect the most recent rate hikes will continue to have a positive impact on earnings. If base rates as of December 31st were in effect for the entire quarter, we estimate that our adjusted net investment income per share would have been about $0.03 higher resulting in adjusted NII of $0.64 per share.

Now, moving to the balance sheet. OCSL’s net leverage ratio at quarter end increased from the September quarter to 1.24 times based on our robust and opportunistic originations in the quarter, lower repayment activity, and a modest decline in NAV. Leverage is now towards the higher end of our target range of 0.9 times to 1.25 times debt to equity. However, leverage will come down slightly on a pro forma basis with the OSI 2 merger to approximately 1.16 times. As of December 31st, total debt outstanding was $1.5 billion and had a weighted average interest rate of 5.6%, up from 4.4% at September 30th due to higher base rates. Unsecured debt represented 43% of the total debt at quarter end, down modestly from the prior quarter. At quarter end, we had ample liquidity to meet our funding needs with total dry powder of approximately $357 million, including $17 million of cash and $340 million of undrawn capacity on our attractively priced credit facilities.

Unfunded commitments — excluding unfunded commitments to the joint ventures, were $172 million with approximately $130 million of this amount eligible to be drawn immediately as the remaining amount is subject to certain milestones that must be met by portfolio companies. Shifting to our two joint ventures. At quarter end, the Kemper JV had $409 million of assets invested in senior secured loans to 59 companies, up from $385 million last quarter, primarily driven by $25 million of additional contributions from the company and our JV partner, as well as new originations and partially offset by declines in the portfolio due to market credit spread widening. The JV generated $2.6 million of cash interest income for OCSL in the quarter, up from $2.2 million in the fourth quarter as a result of the portfolio’s continued strong performance and the impact of rising interest rates on floating rate investments.

We also received a $1.1 million dividend, up from $875,000 in the prior quarter. Leverage at the JV was 1.4 times at quarter end, unchanged from the prior quarter. The Glick JV had $137 million of assets as of December 31, down from $147 million at September 30. These consisted of senior secured loans to 40 companies. Leverage at the JV was 1.3 times at quarter end, and we received $1.9 million of principal and interest repayment on OCSL’s subordinated note in the Glick JV during the quarter. In summary, we are very pleased with our financial results for the quarter. We continue to believe that our solid portfolio and strong balance sheet position us well for the remainder of the fiscal year. Now I will turn the call back to Matt.

Matt Pendo: Thank you, Chris. Our strong financial results for the quarter enabled us to generate an annualized return on adjusted net investment income of 11.9%, up from 10.7% in the prior quarter. While we are very pleased with the growth in our earnings over the past several years, including our solid first quarter results, we believe OCSL remains well positioned to maintain and even build upon our strong ROE going forward. First, we believe OCSL continues to be positioned well for this rising rate environment, with 87% of our investment portfolio in floating rate assets, we expect to further benefit from the remaining interest rate increases that are expected to occur in the next few months. And as we have discussed on prior calls, we continued to benefit from higher ROEs being generated at our joint ventures.

During the first quarter, both joint ventures delivered ROEs of over 14%, as they are also benefiting from the rising rate environment and our ongoing portfolio rotation efforts. As I noted earlier, we expect that the cost savings and management fee reductions resulting from the OSI II merger will also support our returns. In conclusion, we are very pleased with our strong start to the fiscal year. Our portfolio is healthy, and we are well positioned to continue to capitalize on this increasingly attractive investment environment with our ample dry powder. Thank you for joining us on today’s call and for your continued interest in OCSL. With that, we’re happy to take your questions. Operator, please open the lines?

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Q&A Session

Operator: We will know begin the question-and-answer session. Thank you. And our first question is coming from Melissa Wedel from JPMorgan. Melissa, please go ahead.

Melissa Wedel: Good morning. Thanks for taking my questions today. First, I just wanted to say thanks for the information that you provided sort of pro forma for the combined portfolio. I think it was slide 18 in the deck. Unless, I missed it, I was wondering, if you could help us think about what that combined pro forma portfolio yield looks like. With OSI 2 a little bit lower yielding than OCSL?

Matt Stewart: Hi. It’s Matt Stewart. The pro forma yield is going to be pretty much unchanged post merger. The overlap from OSI 2 into OCSL was around 97%. So, significant overlap, and so there’s no material move in the portfolio yield.

Matt Pendo: I think, Melissa, it’s Matt, as you think about kind of the merger, I think the question €“ and you build the pieces, to Matt’s answer the portfolios are pretty much identical. We’ve got tailwind from rising rates that Chris talked about. We’ve got the cost synergies, $1.4 million operational synergies, plus $200,000 to $300,000 of interest expense plus the fee waiver and you kind of add all those together to kind of build your €“ if you look, kind of your March quarter.

Melissa Wedel: Got it. That’s very helpful. Thanks. And I assume the floating rate exposure would be similar as well given the high degree of portfolio overlap.

Matt Pendo: Yes.

Melissa Wedel: Got it. Okay. That’s my two questions. I’ll hop back in the queue. Thanks.

Operator: Our next question is coming from Bryce Rowe from B. Riley. Bryce, please go ahead.

Bryce Rowe: Thanks. Good morning. Wanted to maybe start on just the origination activity for the quarter, a nice strong quarter from a commitment and funding perspective, wanted to get a sense for you all if this quarter’s activity was more kind of seasonal strength, or would you say the opportunity set was just more attractive here in the December quarter?

Armen Panossian: Thanks for the question, Bryce. It’s Armen. So I think that, in the first half of 2022, pricing on the sponsor side of the market was generally not that attractive. We were very cautious about what we were doing on the sponsor side for most of the year. But beginning in August and September, it seemed like there was an air pocket in the market, especially on the sponsor side, pricing widened legal terms improved. And we’re able to originate some very attractive sponsor and non-sponsored transactions. I think, it’s hard for me to say that, it was a seasonal thing. But our activity was faster than what it had been because of the quality of the deal flow, the pricing of it, the lower loan to values, the better legal terms.

So I wouldn’t characterize it necessarily as seasonal, but it certainly was opportunistic, and I would say that in January, it’s been a little bit slower, but we have been building up a decent pipeline for the rest of the first quarter and into second quarter. So I think there was a little bit of a rush to get deals done in November and December that is now resulting in sort of pulling forward of deals that would have otherwise occurred in January. I don’t know if you would call that seasonal, but it’s — these are kind of situations that have different time line. So I think that just in light of the fact that we saw some good deals, we really pushed heavy in the fourth calendar quarter to get that — to get those deals done.

Bryce Rowe: That’s helpful, Armen. And then just around pricing of the new commitments, you highlighted a 13% plus weighted average yield, are you still seeing that level? And I think you mentioned at least you called out to specific investments. It sounded like both of those carry pricing that was around that level that you highlighted as far as the weighted average yield for the new commitments for the quarter. So I’m just trying to get a feel for whether that’s an anomaly, or you’re still seeing that level of pricing on actionable opportunities in the current environment?

Armen Panossian: Yeah. I would say the frequency of our deal flow, if you were to line up the pipeline that we have, there is a little bit of a difference between sponsor-led deal pricing versus non-sponsor. The non-sponsored is certainly in that 13, 14, sometimes higher ZIP code. The sponsor deals that we’re doing these days are pretty much always first lien. The pricing is pretty much in the SOFR plus $650 million to $700 million range and with SOFR 4% and with OIDs on origination of two or three points, they’re solving to about 12% — 11.5% to 12% for sponsor-led deals. So it is, I would say that most of the deals we’re seeing are a little bit shy of 13%, but not a lot. Not — I wouldn’t say several hundred basis points lower, it’s maybe 100 or 150 basis points lower.

I do think that as long as base rates stay where they’re at and as long as the market technical stay in this type of dynamic where there’s a more balanced interaction between lenders and private equity sponsors. That this type of pricing in the, call it, 11% to 14% range is possible.