Oaktree Specialty Lending Corporation (NASDAQ:OCSL) Q2 2024 Earnings Call Transcript

Oaktree Specialty Lending Corporation (NASDAQ:OCSL) Q2 2024 Earnings Call Transcript April 30, 2024

Oaktree Specialty Lending Corporation reports earnings inline with expectations. Reported EPS is $0.57 EPS, expectations were $0.57. OCSL isn’t one of the 30 most popular stocks among hedge funds at the end of the third quarter (see the details here).

Operator: Welcome and thank you for joining Oaktree Specialty Lending Corporation’s Second Fiscal Quarter Conference Call. Today’s conference call is being recorded. At this time, all participants are in a listen-only mode. But we 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, you may begin.

Michael Mosticchio: Thank you, Operator, and welcome to Oaktree Specialty Lending Corporation’s second 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. Joining us on the call today are Armen Panossian, Chief Executive Officer and Chief Investment Officer; Matt Pendo, President; Chris McKown, Chief Financial Officer and Treasurer; and Matt Stewart, 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, 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 solicitation of an offer to purchase any interest in any Oaktree Fund. Investors and others should note that OCSL 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 for joining us today and for your interest in and support of OCSL. Our second quarter was highlighted by robust origination activity that drove a positive shift in the composition of our portfolio, steady earnings and progress on several non-accruals that led to an improvement in credit quality. Adjusted NII was $0.56 per share, roughly in line with the $0.57 per share for the prior quarter. These results reflect the ongoing strength in the earnings power of OCSL, including solid interest income from our predominantly floating rate portfolio. However, our results were impacted by the timing of repayments, which primarily occurred at the start of the quarter and capital deployments, which were concentrated towards the end of the quarter.

In addition, our continued rotation into primarily first-lien loans reduced our weighted average portfolio spread by approximately 10 basis points in the quarter. Our first lien investments have increased from 71% at September 30, 2022 to approximately 81% today. At the same time, second-lien investments decreased from 16% to 5% over the same period. We declared a dividend of $0.55 per share consistent with the past five quarters. We also work closely with the management teams of our underperforming portfolio companies and made important progress repositioning several investments during the quarter. Drawing upon our long history and proven expertise in turning around challenged investments and leveraging the deep resources of Oaktree, we are confident that we can continue to successfully maximize outcomes and deliver value for our shareholders.

The successful restructuring of some of our non-accrual positions as well as no new non-accruals enabled us to drive improved credit quality during the quarter. Investments on non-accrual status at quarter end represented 2.4% of the portfolio at fair value and 4.3% at cost. That was down from 4.2% of the portfolio at fair value and 5.9% at cost the prior quarter. NAV per share declined to $18.72 from $19.14 per share for the prior quarter. The decline reflected further markdowns on certain of our nonperforming investments due both to restructurings on some, as well as lower valuations on others. Our robust investment activity consisted of $396 million of new commitments in the quarter, building on the momentum from the prior quarter when we originated $370 million of new investments.

We continue to find attractive opportunities across sponsor, non-sponsor and publicly traded credit investments bolstering healthy deal flow even as we maintain our highly selective approach to investing amid the uncertainty in this current higher for longer interest rate environment. Importantly, our new originations were made at attractive yields with lender-friendly deal structures. This included lower leverage and loan to values. To that end, the weighted average yield on our new debt investments was 11.1%. On the repayment front, we received $323 million from pay down and exits in the second quarter. Our portfolio continues to receive steady levels of repayments even in a less active M&A environment. We have also been capitalizing on the strength in the liquid credit markets by opportunistically selling out of certain public debt investments.

Over the past two years, over 50% of our portfolio has turned over, which we believe reflects the strength of our investment underwriting and selection process. Exits occur largely when these companies prove successful and have the ability to pay down debt, refinance at lower rates or sell at attractive valuations to larger competitors. We pursue opportunities and make investment decisions with these outcomes in mind. Before I turn the call over to Armen, I wanted to highlight a significant action that our manager has taken in support of OCSL. As part of our strong commitment to aligning our interest with shareholders, we announced yesterday that Oaktree has agreed to a significant and permanent reduction in our base management fee to 1% on gross assets from 1.5%.

As a reminder, Oaktree has been waiving $1.5 million of management fees each quarter as part of the OSI2 merger that closed in January of last year. For the original agreement, those fee waivers will decrease to $750,000 per quarter for the second year following the close of the transaction, which occurred this January. However, Oaktree agreed to keep the fee waivers at $1.5 million per quarter for both the March and June 2024 quarters. We expect this reduction will increase OCSL’s adjusted net investment income per share by approximately $0.15 annually. This equates to an estimated improvement in our return on adjusted net investment income of 0.8% annually. Bottom line, this lowers our cost of operations and allows a larger share of investment income to flow directly 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 our portfolio activity and then conclude with observations regarding the market environment. Our portfolio was well diversified with $3 billion at fair value across 151 companies at the close of the quarter. We remain focused on investing at the top of the capital structure with 86% of the portfolio invested in senior secured loans, consistent with the prior quarter. First-lien loans accounted for 81% of the portfolio at fair value. We also continue to emphasize investments in larger and more diversified businesses to further mitigate risk. Median portfolio company EBITDA as of March 31 was approximately $134 million, roughly in line with the prior quarter.

And leverage in our portfolio companies was steady at 5.2 times, well below overall middle market leverage levels. The portfolio’s weighted average interest coverage based on current base rates was also steady at nearly 2.0 times. In the March quarter, we leveraged Oaktree’s platform to originate $396 million of new investment commitments across 35 transactions. Our originations were dispersed across a broad array of opportunities, spanning the private credit and public debt markets, including 14 private deals, six primaries and 15 secondary purchases. Notably, we participated in five private sponsor-led transactions where Oaktree’s size, reputation and ability to underwrite and fund quickly enabled us to participate. We also found compelling relative value in the public credit markets, purchasing $191 million across primary new issues and secondary market purchases.

92% of our originations in the quarter were first-lien investments, reflecting our defensive investment approach and the average yield for all of our originations was 11.1%. Our origination activity remains steady in the current quarter, supported by a robust pipeline of opportunities across sponsor and non-sponsored borrowers. Turning to credit quality. As Matt noted, our non-accruals decreased during the quarter as we made significant progress working through these situations. This was driven in part by the removal of OTG Management from non-accrual status. As a reminder, this company operates a concession business across several airports in the US. OTG has a solid business model and is performing well, but was struggling to meet its higher interest expense burden from the increase in base rates.

As a result, it restructured its balance sheet out of court in February, resulting in lenders forgiving a portion of their debt in exchange for equity in the company. We placed this investment back on accrual status following the restructuring eroded down quarter-over-quarter to reflect cash declines tied to the restructuring costs. Additionally, we partially removed from non-accrual our investment in all web leads, which generates leads for insurance companies. As a reminder this is a non-core position we inherited from the prior manager in 2017. The company completed a restructuring of its debt in March, replaced two tranches of the restructured debt back on accrual status as the company is back on solid financial footing, and focused on executing on its strategic initiatives.

We also removed CPC Acquisition Corp. a small public second lien from non-accrual after we sold out of our position following an improvement in its secondary trading levels. I also wanted to provide an update on Thrasio, an Amazon aggregator that we placed on nonaccrual last quarter. We have been working with the management team and lenders to support liquidity and position the company for long-term success. In late February, the company filed for bankruptcy protection to strengthen its financial position and deleverage its balance sheet in a protected lender-led financing. As a result of this, we wrote off our preferred equity investment and marked down our term loan. Our overall portfolio is in solid shape. We view recent challenges faced by companies placed on non-accrual as idiosyncratic and not indicative of broader or systemic issues within the portfolio.

Of course, we are closely monitoring all of our investments, given persistently high interest rates and the potential for these increased borrowing costs to create stress for some companies. With that in mind, I’ll turn to our view on the market environment. Over the past six months, credit markets have experienced widespread rally, leading to historically tight spreads across the leveraged loan and private credit market. The market strength has multiple drivers including supportive capital inputs, but the overall trend remains driven by investor confidence in the soft landing that will lead to a meaningful decline in interest rates. While we aren’t overly bearish about the U.S. economy or the inflation outlook, we believe downside risks may outweigh the upside, given that markets have already priced in overly optimistic expectations.

Specifically we are skeptical about the pace and extent of interest rate declines, anticipating a more modest trajectory than what is currently priced in. As such, rates could remain elevated compared to where they were prior to 2022, which could pose challenges for borrowers with high debt loads or companies that will need to refinance our debt in the coming years. Against this backdrop we continue to exercise caution. We will remain selective and prudent as we apply our investment approach that prioritizes relative value, drawing upon Oaktree’s substantial resources and expertise to selectively invest across private and public credit markets. Importantly, we remain well capitalized with ample liquidity to navigate near-term volatility and continue to construct the portfolio for strong long-term performance on behalf of shareholders.

Now, I will turn the call over to Chris to discuss our financial results in more detail.

Chris McKown: Thank you, Armen. As Matt noted, we reported adjusted net investment income of $44.7 million or $0.56 per share as compared with $44.2 million or $0.57 per share in the first quarter. The slight increase on a dollar basis was primarily driven by a modest decline in net expenses due to lower Part I incentive fees, professional fees, and interest expense in the quarter. This was partially offset by slightly lower adjusted total investment income. The per share decrease for the quarter was driven by an increase in weighted average shares outstanding. Adjusted total investment income decreased by $700,000 in the quarter and was adversely impacted by a $1.9 million decrease in interest income, due primarily to the result of the timing of capital deployment and spread compression, primarily resulting from the rotation out of higher-yielding second liens.

This was partially offset by a $1.2 million increase in fee income, resulting from prepayment and amendment fees and higher OID acceleration from investment repayments. We’d note that our GAAP financial results were lower due to purchase price premium acceleration from the par repayments of certain investments acquired in the mergers with both OCSI and OSI2. Net expenses for the second quarter totaled $52.7 million, down $1.1 million sequentially. The decline was mainly driven by $0.6 million of lower Part I incentive fees, $0.3 million of lower professional fees, and $0.3 million of lower interest expense. As Matt highlighted, Oaktree agreed to waive the total $3 million of base management fees over the March and June quarters at a rate of $1.5 million per quarter.

Starting on July 1, 2024, our new 1% base management fee will go into effect and will be calculated net of the base management fees that Oaktree agreed to waive as part of the OSI2 merger. Shifting to our balance sheet. We maintain a strong capital position with ample liquidity. Our net debt to equity remains on the low end of our target range at about 1.02 times, providing us plenty of room to grow leverage should we find more compelling opportunities in the market. Newly funded investment activity of $377 million exceeded proceeds from repayments, exits and sales of $323 million, enabling us to grow the portfolio. As of March 31, total debt outstanding was $1.68 billion and had a weighted average interest rate of 7.0%, including the effect of our interest rate swap agreements, consistent with the level at the end of the December quarter as interest rates remained steady during the quarter.

Unsecured debt represented 57% of total debt at quarter end, also in line with the prior quarter. Our balance sheet was further bolstered through continued share issuance under our ATM program. We were able to capitalize on the constructive market environment to raise $46 million of common equity in the quarter to fund our pipeline. These shares were issued at an average 104% premium to our NAV. Our liquidity is strong with approximately $1 billion at quarter end, including $125 million of cash and $888 million of undrawn capacity on our credit facilities. Unfunded commitments — excluding unfunded commitments to the joint ventures were $209 million, with approximately $179 million eligible to be drawn immediately, whereas the remaining amount is subject to certain milestones that must be met by portfolio companies before funds can be drawn.

Turning now to our two joint ventures. Our JVs, again, delivered another quarter of strong performance. Together, the JVs hold $504 million of investments, primarily in broadly syndicated loans spread across 56 portfolio companies. For the quarter, the JVs again generated attractive annualized ROEs, which combined were nearly 14%. Leverage at the JV increased to 1.3 times in aggregate at quarter end due to the addition of assets to the portfolios in connection with our partners. In summary, we are pleased with our financial results and the progress we’ve made to date on our challenged investments and continue to believe that our strong balance sheet positions us well for the second half of fiscal year 2024. Now I will turn the call back to Matt for some closing remarks.

Matt Pendo : Thank you, Chris. We are pleased by the growth in our earnings over the past several years, and our financial performance for the second quarter further demonstrates the resilience of those earnings. Our return on adjusted net investment income for the quarter was 11.7%, which once again, is at the higher end of our targeted range, and our dividend continues to be covered by earnings. Looking ahead, we are being proactive with our non-accrual investments and have plans in place that we believe will optimize the recovery for each investment. In addition, our new fee structure and ongoing fee waivers will be accretive to our ROE effective immediately. All-in-all, we are quite optimistic about our future and look forward to building upon our long-term track record of delivering attractive returns to our shareholders.

As always, we appreciate your participation on the call today and for your interest in OCSL. With that, we’re happy to take your questions. Operator, please open the lines.

Operator: We will now begin the question-and-answer session. [Operator Instructions] Our first question comes from Brian McKenna with Citizens JMP. Please go ahead.

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Q&A Session

Brian McKenna: Okay. Great. Thanks. Good morning all. So a question on the dividend and the management fee reduction. So if I annualize second quarter results and then add the $0.15 to that, so the fee change, dividend coverage is still less than 110%, and that’s before any reduction in interest rates and then any other changes in underlying credit across the portfolio. So what makes you confident you’ll be able to fully earn the dividend looking out over the next 12 to 18 months, assuming the forward curve plays out? And then can you remind us what your earnings sensitivity is to every 100 basis point move in rates?

Matt Pendo : Sure, Brian. Thanks for the question. So at a high level, we feel very comfortable given the change in the management fee, which was given to 1% as of July 1st and our ability in the future to cover our dividend and feel good about the dividend. One of the things this quarter that impacted the results were just some inter-quarter timing in terms of repayments than fundings. So there was a little bit — I wouldn’t necessarily take this quarter and just annualize it. So as we think about adjusting for that timing difference as we look at our pipeline and the fundings that we’ve done this quarter, as well as — already this quarter but then for the balance of the quarter, the fee waiver et cetera we feel — you add it all together, we feel very comfortable with covering the dividend. So I think the one thing is just focus on the timing of the quarter, and then just our pipeline as we see it.

Brian Mckenna: Got it. Okay. Helpful. And then shifting gears a bit here. Just looking at the investment portfolio, it’s experienced solid growth year-to-date. It’s up about 5%. So what’s your expectation around new investment activity, as well as prepayments for the next couple of quarters? And I’m just trying to get a sense of the trajectory of the portfolio from here?

Armen Panossian: This is Armen. We have already funded $100 million this quarter, so the second calendar quarter. We do have a pretty healthy pipeline for the balance of the quarter in terms of new fundings. I don’t have a very good sense for unexpected repayments obviously. But I do think that the market is opening back up and we are seeing more M&A deal volume or deal activity that we could potentially consider as part of — or for a direct loan. And our public market activities are — we remain quite active there. We will deploy when it makes sense in the public markets as well. We continue to watch that for periods of opportunity or potential volatility that makes sense. But I think that this quarter, we will have another strong quarter for originations just based on what we know about the pipeline. I’m not sure I could guide to a more specific number. But the $100 million in the month of April, I think is a good start so far.

Brian Mckenna: All right. I’ll leave you there. Thanks for taking my questions.

Operator: The next question comes from Finian O’Shea with Wells Fargo. Please go ahead.

Finian O’Shea: Hi, everyone. Good morning. So first question looking at origination this quarter, it’s some private participation, some public deals. There’s not much spreader OID. So does this — combining that with the fee cut, does this mean things are going this way and the fee cut is just an offset to the returns you expect to be generating?

Armen Panossian: Hey, Fin it’s Armen. The portfolio over the last couple of years has migrated to a substantially higher percentage of first lien, kind of, a reflection of our view of risk in the markets. We’re now 80% first lien. We were 60%, 24 months ago, 36 months ago. And for a portfolio that is largely first lien, I would say on balance might even increase in our first-lien exposures. As we looked at the appropriate aligning level of management fee over the long run, we thought that 1% was more adequate or more consistent. And I think the markets are going to ebb and flow. I think the spreads will — obviously they have tightened over the last 18 months they may widen. We’re not making a prediction on that. But we do think that the best way to deliver low volatility and dependable dividend for our shareholders is to continue to do what we have been doing around the first lien migration, which we thought that now would be a good time as any to reduce the fee and deliver that continued stability to our shareholders.

That’s really what’s driving it. It’s not a forward prediction about spreads. That we’re not, it’s just very hard to make any sort of prediction on that. But the market certainly has tightened over the last 18 months vis-à-vis spreads.

Finian O’Shea: That’s helpful. Thank you. And a follow-up on the related non-traded BDC or group runs that looks to be moving along at say $150 million a month. Can you talk about perhaps resources that you and Brookfield are putting into it the platforms you’re on the distribution force and like where you’re sort of hoping this goes to as say a monthly cadence or total size?

Armen Panossian: Yes Fin I don’t really have a projection on what we hope or expect for the monthly cadence to go to. I could tell you that our investment team and teams at Oaktree continue to grow, in terms of resources both in terms of sourcing and analytics. Brookfield and Oaktree do have a partnership on the wealth solutions channel called Brookfield Oaktree Wealth Solutions. That is responsible for our activities on the non-traded BDC side, as well as other products for the retail channel. It’s not something that is a distraction or burden for the investment team at all. And I think that as we have grown across our multiple channels including institutional, it’s just made Oaktree a more I would say powerful counterparty in the markets providing the whole capital structure solutions and then in partnership with our…

Finian O’Shea: Okay – sorry to interrupt but at what level would it be a distraction or burden if say $150 a month is just a sort of breeze for you? Like where should we be alarmed or looking at it or…

Matt Pendo: Fin, it’s Matt. So we’ve been raising about $150 million a month for two years. So that’s been a steady cadence. Like I don’t – as Armen said, we don’t make predictions about where that’s going to go but that’s where it’s been and it’s worked just fine and works fine for that BDC, works fine for the rest of Oaktree and our resources. So I don’t – I wouldn’t spend too much time kind of hypothesizing what could happen with this and everything. It’s been – doing $150 million that works well for that BDC works well for Oaktree and that’s just kind of how we’re thinking about it.

Finian O’Shea: Awesome. Thank you once and all. I’ll hop back in the queue.

Armen Panossian: Thanks, Fin.

Operator: The next question comes from Kyle Joseph with Jefferies. Please go ahead.