Erik Zwick: To start just asking a question about the weighted average yield on the new debt commitments here in the most recent quarter at the 9.9%, which was kind of below the 10.6% in the whole portfolio, and I would have expected that to be maybe higher to what you referenced that you’re seeing in October, with the 12 handle on it. So, curious if you could just provide any color whether that was related to some certain specific borrowers that were larger, maybe lower risk or things like that that drove that yield up in the most recent quarter here.
Armen Panossian: I can’t say that I have an apples-to-apples comparison that would help you would help you figure out the differences. I don’t think that the new origination in October is at all reflective of higher risk. I think it’s just kind of borrower specific — borrower specific one to the next that creates a little bit of a delta. But I don’t — I can’t say that I have any sort of specific comparison that would help answer that question. We did, however — I think one maybe driver of that is we did buy some large hung bridge loans that you might have heard of in the market that were hung on the bank balance sheets as well as some small issuances that were also hung. And generally speaking, I would say the yield to maturity on those positions was lower than what we typically see on our private.
So, I think that might have skewed the numbers a little bit. But what I would say about those purchases, whether they’re the hung deals or the bonds, they are at dollar prices that are meaningfully lower than the average in the market and create an opportunity for convexity and a pull to par in a very high-quality credit and over a recovery period of two or three years rather than to maturity. The total return opportunity in those types of situations would either meet or exceed that what we typically would see in a near par price private loan. So, I think there is a little bit of a — maybe a little bit of a disjoint therapy when you’re buying discounted paper in the public market and you’re comparing against near par paper in the private market, there is a yield to maturity difference, but probably not a yield to recovery basis.
Erik Zwick: That makes sense. Thank you for the explanation there. And then a question I had today was regarding — I think you mentioned for your portfolio companies, the debt service coverage ratio was down quarter-over-quarter from 3% to 2.7%. But that 2.7% is still, I think, meaningfully above a number of your peers. I’m just curious as you’re talking to your company, staying in touch with them, how are they feeling about the operating environment? Are they slowing down investment for growth or potentially deleveraging in light of having their interest go up, or how are they feeling at this point that you can provide any anecdotal evidence there?
Armen Panossian: Sure. And this will be kind of raw, but I would say, first of all, the decline in the fixed charge coverage is mainly due to an increase in base rates. It isn’t really due to any sort of degradation on — in a meaningful way of credit quality or of performance. But with that said, I would make the following comments. The first is, generally speaking, companies that we cover in the market, either in our portfolio or outside of our portfolio, are seeing rising commodity and labor costs and the impact that that has on their bottom line. And therefore, they are increasing prices. So generically, I would say companies are seeing increases in revenue, really driven by higher prices rather than greater volumes sold.
But that is being offset by the labor and commodity cost inflation. And therefore, on a cash flow — from a cash flow perspective or an EBITDA perspective, they aren’t seeing tremendous growth on that line generally. I would say there’s some that are doing better on the EBITDA line, some doing worse. And I think they are all being mindful of cash balances and liquidity because of the uncertain economic backdrop that we’re in right now. I wouldn’t say that anybody is kind of ringing the alarm bells and worrying too much about an increase in default rates right now. But it is a risk factor that we watch very closely in the market, in our portfolio and look to, as best as we can, make sure that we are invested in companies that could or would weather an economic cycle really well, with excess cash flows with levers that they could pull to manage their liquidity to what could be a rough patch, but obviously, nobody knows right now.
Operator: Our next question will come from Ryan Lynch with KBW.
Ryan Lynch: First question I had, I wanted to follow up on your commentary regarding the hung deals. I think you said you had two hung deals that you guys participated in, in the September quarter. I would just love to hear what was the thought process behind those deals? How is that market activity going right now? Are you seeing a lot of those in the marketplace? Is that a market that you expect to participate in? And then also, on that note, what were the size of those two hung deals? And then also, where do you guys classify those in your security types? Are those classified as private placements because you guys only had about $4 million of the secondary market. I would have thought those would have been classified as secondary market purchases.
Armen Panossian: Great. So, we bought $10 million to $12 million of each. Both were first lien primary issuances. I don’t think they’re listed as private placements or primaries. So, we list them as primaries on the balance sheet. Now, in terms of the market overall, these — the hung deals tend to be the largest deals in the market that we’re committed to by the investment banks over the last 12 months. They are typically not small deals for those banks. They’re — the hold sizes or the commitment sizes for the banks are in the billions. And so, the reason that’s important is these tend to be very, very large borrowers owned by very, very large private equity firms putting in very, very large equity checks. They tend to be the leaders in their respective industries.
And so from an underwriting perspective, ignoring the capital structure for a moment, these companies tend to be quite stable through cycles. And so, when we see that, we say, okay, well, what is the right price for these positions, given the underlying market backdrop. And we noticed that in light of how large these loans are and how dislocated the bank syndication market is right now, that there is a technical imbalance that has overshot the risk profile of the underlying credits. In other words, the technical profile is far worse than the credit profile is of these particular investments. Now, are there a lot of these? Not really. There are dozens and dozens of hung loans that we would be willing to consider. But there are several that are in the market now, both in U.S. and in Europe.
And just given Oaktree’s global reach, we do and are looking at several of these types of situations. I wouldn’t be surprised if we participated in more, but they’re all considered on a one-off basis. They’re all sort of credit by credit, bottoms-up underwriting as we would do in a private deal and just taking advantage of the technical imbalance that is causing the banks to sell these positions at material losses, and create an attractively priced and yielding asset for the BDC.
Ryan Lynch: Okay. That makes sense and that’s helpful color on kind of the thought process of surrounding those deals and what you’re thinking about going forward. Another question I had was — you guys have set out — I think you guys have operated the business at a pretty conservative leverage ratio. And I think you’ve spoken about you want to keep a conservative leverage ratio and then, during times of dislocation, to opportunistically grow leverage during those dislocations. How would you view today’s marketplace? Because clearly, there’s very attractive deals that are occurring in the marketplace today regarding spreads, leverage, LTVs, those sort of things. But yet, there also hasn’t been a lot, I would say, disruption yet flowing through the financials of businesses today.
That’s — maybe there’s some, but that’s certainly going to grow over the coming quarters and into 2023. So, do you view an environment today with significantly better structures and terms on deals yet we haven’t really seen the financial disruption yet? Do you view that as an opportunistic environment to grow your portfolio, or do you have to see that decline in fundamentals of these businesses first that would further dislocate the market where it would be a time to opportunistically grow your portfolio?
Armen Panossian: Yes. It’s a good question. And I think what you need to do is separate technicals from fundamentals. So to your point, the fundamentals, broadly speaking, in the market are showing some cracks. The — I wouldn’t say that — sorry, the fundamentals are showing some cracks in the economy. They are not to the level that I would say is indicative of deep distress or rescue lending opportunities. We have not seen a material uptick in rescue lending opportunities at this time, like we did in 2020. During the second and third quarter of 2020, we were very actively increasing our leverage profile because we did see those types of — both market and economic dislocations that created outsized return opportunities in a very managed risk profile.
That is not the case right now. So fundamentally, the economy is not at the place where I would say it’s maximum pain. However, the technicals and the markets generally are ahead and remain ahead of the economy in most normal market cycles. Equity markets, debt capital markets are usually moving in anticipation of fundamental changes in the economy. And so, you will always get a situation where the market overshoots the fundamentals, but then the fundamentals sort of catch up and you have a little bit of normalcy. And sometimes the markets actually rebound faster, and you often see a rebound in the market as the fundamentals in the economy are actually bottoming. If you look at buyer cycles, that actually occurs quite frequently. So, it’s hard to time it where you have both occurring you have to be mindful of the structures that you put in place and the technical pressures in the market around fund flows that may be causing a competitive dynamic that’s less than attractive.
And you have to weigh that against potential future degradation and economic performance of the underlying companies and their ability to pay their principal and interest and other fixed charges. So right now, what would I say in terms of fundamentals versus technical? Is it a great environment to increase leverage? We’re seeing great pricing opportunities. We are seeing widening in sponsor-led sponsor-owned private credit. We’re seeing a widening in pricing and improvement in terms in that regard and the sponsor side as well as the non-sponsor side, a decline in leverage on a per-deal basis. I would say, generally speaking, sponsors are putting in more equity in deals are considering these days versus 6 or 12 months ago. So, all things are pointing to a more rational market because there are there are direct lenders and other investors that have taken a step or half a step back from the markets and created a more rational negotiating dynamic between borrowers and creditors.
So, that’s good. But could it get worse? Absolutely. And so, we are going to continue to reserve our leverage because we think that there probably will be some alpha-generating opportunities in direct lending over the next few quarters.
