Armen Panossian: Thanks, Kyle. This is Armen, again. So credit quality, I think, you’ve got to parse out the two pieces that influence credit. First is unlevered performance of companies and the second is the elevated cost of borrowing. In terms of the unlevered performance of companies, I would say that, generally speaking, if the company has not been a beneficiary of inflation. So, for example, an energy-related company or a commodity company that benefits from inflation, assuming the way — assuming that is not the case, the typical borrower in the US, generally speaking, has raised prices, and therefore, revenues are generally up and were up in 2022 year-over-year. However, the pace that — of inflation in the cost structure has outpaced the revenue increases generally for companies.
So I would say that, while revenues are up, dollars of gross profit or dollars of EBITDA have not materially changed, and, in some cases, might have even declined. So the EBITDA margin or gross margin of these businesses, I would say, by and large, is flat to down, even though revenues are up. And that — it’s very generic statement. Obviously, there are exceptions to that type of generic statement. But I would say that the unlevered performance in an inflationary environment is troubling because, with the increase in prices that companies have passed through to their customers, we are approaching the point where, in some industries, there’s demand destruction and you’re seeing a slowdown in the growth rate of quantities sold. So that’s something we’re watching closely.
I would say, there isn’t a very rosy picture, an upside picture for unlevered performance of companies. I don’t think any business is just crushing it and doing a great job, inflation notwithstanding. Now in the case of leverage free cash flow, which is, obviously, cash flow after the cost of — the elevated cost of borrowing, that is a problem, especially as base rates become consistent through the quarter. I mean, they’ve — base rates have been increasing for the last 9 months, 12 months. And every quarter, you sort of — you have a lagged impact of base rates as the SOFR or LIBOR contracts reset, base rates continue to rise in the fourth calendar quarter. And in fact, our dividend or our ROE on our portfolio would have been higher at base rates at the end of the quarter were the same at the beginning of the quarter.
So, there is certainly some catching up of — in company performance because there is a lagged effect on the cost of borrowing rising through quarters. So that doesn’t bode well for borrowers. It’s great for the yield on portfolio for investment managers like us, but for borrowers, obviously, it has become a material change in their performance on a levered basis. A lot of these businesses ignoring our portfolio, but let’s just look at the market overall, direct lending was pricing at LIBOR plus 500 to 550 generically for the last three or four or five years. When LIBOR was at 25 basis points, these companies at a 1% LIBOR floor, so those — that cost of debt at the time of issuance was 6% to 7%. Now, you have a 300 basis point increase in SOFR above that LIBOR floor, which is a 50% increase in the cost of borrowing for the unhedged borrower.
That’s pretty material in light of the fact that on an unlevered basis, the corporate performance of these companies is challenged, as I mentioned earlier in my answer. So, I do expect for there to be elevated risk in portfolio generally elevated defaults, especially in broadly syndicated loans. In direct lending, it’s hard to say if the risk will translate into default because of the bilateral nature of lenders and borrowers in the direct lending landscape. So, I think defaults will probably be muted, but the reality is that there will be stress in portfolios that will need to be handled by direct lenders, especially those lenders that have been that have been supporting highly levered LBOs over the last few years at pricing of LIBOR plus 500 because they will have borrowers that are the most stretched in terms of debt to EBITDA and the most stretched in terms of interest coverage ratio.
So, it’s something to watch. And I think the default rates on broadly syndicated loans will rise and that should be a proxy for what’s happening in terms of stress in direct lending portfolios.
Kyle Joseph: Got it. And then one quick follow-up for me. Just in terms of your prepayment or repayment pipeline, it doesn’t sound like the merger should have really any material impact on that given the overlap, but kind of the outlook for repayments broadly in 2023, given all the moving parts macro-wise?
Armen Panossian: Yes, it’s a good question. It’s hard to predict. But I would say that our non-sponsored deal flow, the characteristics that those borrowers have are that they took on leverage from us to achieve a strategic goal, not to financially engineer equity results. So, when those strategic goals are accomplished, we get repaid. We got repaid on several transactions that met this definition in 2022. We have some expected repayments over the next several months, again, in the non-sponsored area where we lend to businesses that were experiencing some growth and they had to make some capital expenditures to sustain that growth. So, we — and that cost of debt, as I mentioned, on non-sponsored lending is generally higher than sponsor lending, which means that we are going to look very expensive when these businesses to achieve their goals.
And so we expect to get paid off, refinanced in some of those non-sponsored transactions this year. On the sponsored side, it’s hard to see that happen. Sponsor LBO transaction volume seems to be declining because of the elevated cost of borrowing on new deals, which means that a lot of sponsored businesses that are in our portfolio or in the markets overall, they’re unlikely to transact from one sponsor to the next or from a sponsor to an IPO, which means that those particular loans on the sponsor side probably don’t see material repayments in 2023. So that’s our expectation. Now with that said, we also do have a publicly traded book. January has been a very strong month. In the publicly traded book we view that over time as a source of cash as well.
And therefore, you might see some “repayments” because of trading activity that we take on. And we will turn that cash around and deploy it into private debt, hopefully, higher yielding, more sort of structured private debt than what you typically see in the market?
Matt Pendo: And just picking up on that, we’ve covered this a bit earlier. It’s Matt, Kyle. The OSI II portfolio has the same liquid makeup as OCSL. So it’s just more of that asset we can rotate out of.
Kyle Joseph: Yes. Got it. Thanks a lot for answering my questions.
Armen Panossian: Thanks, Kyle.
Operator: We will now take a question from Erik Zwick from the Hovde Group. Erik, please go ahead.
