Oaktree Specialty Lending Corporation (NASDAQ:OCSL) Q4 2023 Earnings Call Transcript

Oaktree Specialty Lending Corporation (NASDAQ:OCSL) Q4 2023 Earnings Call Transcript November 14, 2023

Oaktree Specialty Lending Corporation misses on earnings expectations. Reported EPS is $0.62 EPS, expectations were $0.63.

Operator: Welcome, and thank you for joining Oaktree Specialty Lending Corporation’s Fourth Fiscal Quarter and Year-End 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 begin.

Michael Mosticchio: Thank you, operator, and welcome to Oaktree Specialty Lending Corporation’s fourth fiscal quarter and year-end 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, our Chief Operating Officer. Before we begin, I want to remind you that comments on today’s call includes 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 would 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 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. We generated strong fourth quarter and full-year results supported by attractive new deployment activity, elevated repayments, tailwinds from higher interest rates, as well as the completion of our merger with Oaktree Strategic Income II, Inc. or OSI2 in January. Full year fiscal 2023, adjusted NII was $2.47 per share, up from $2.12 for fiscal 2022. These results reflect growth and the earnings power of our portfolio over the course of the year, driven by higher interest income from our predominantly floating rate portfolio, combined with wider spreads on new investments and bolstered by synergies from the OSI2 merger.

We delivered our highest annual level of adjusted net investment income under Oaktree’s management, building upon the momentum we have generated since taking over management of the company six years ago. Based on the ongoing strength of our earnings, our Board approved a quarterly dividend of $0.55 per share, which was consistent with the prior few quarterly distributions. Our Board also declared a special distribution of $0.07 per share in an effort to pay up substantially all taxable income for the year and minimize the possibility of paying excise tax. Now, looking at our fiscal fourth quarter results. Adjusted net investment income per share was $0.62 for the quarter consistent with the prior quarter. We reported NAV per share of $19.63, up $0.05 per share from the prior quarter.

The quarterly increase was mainly the result of earnings in excess of our quarterly dividend and steady marks in our portfolio. Our investment activity was lighter in the fourth quarter at $87 million of new investment commitments. Armen will provide more detail, but in summary, the relatively modest origination total for the fourth quarter reflected the seasonal summer slowdown in our market as well as our highly selective approach to investing amid the uncertainty in the current economic environment. That said, we continue to see a steady stream of opportunities and overall deal flow is healthy as we move into our new fiscal year. Despite the more muted quarter, we had solid originations in full-year 2023, as we leveraged the Oaktree platform to originate over $700 million of new investment commitments, representing about 25% of the portfolio today.

This is particularly noteworthy given these assets were originated during one of the most attractive environments for private credit that we’ve experienced in recent memory, driven by higher interest rates resulting in attractive deal characteristics such as lower leverage and loan to values, better terms and wider spreads. On the repayment front, we received $364 million from paydowns and exits in the fourth quarter. While market activity has been generally slower given higher interest rates and fewer M&A transactions, we continue to receive steady levels of repayment, including in some of our junior debt positions, and we have also been opportunistically selling out of public debt investments. In total, about 30% of our portfolio turned over in fiscal year 2023.

We believe this is attributable to our differentiated portfolio of private loans, and we have also been opportunistically selling some of our public debt based on the recent strength in the credit markets. Over the course of the fiscal year, our portfolio turnover has resulted in a positive shift in our investment composition. We’ve seen our first lien investments increase from 71% as of September 30, 2022, to 76% as of September 30, 2023. At the same time, we’ve experienced a decline in second lien investments, which decreased from 16% to 10% over the same period. This shift underscores our emphasis on improving the risk/return profile of our portfolio and aligning our investments with the ever evolving market conditions. Credit quality improved modestly during the quarter and remained solid overall, with four investments in non-accrual status at quarter end, representing just 1.8% of the portfolio at fair value and 2.4% of the portfolio at cost.

As I noted earlier, the merger with OSI2 continues to positively impact our business. We have been realizing the benefits of scale gained from the transaction remain on track to achieve $1.4 million worth of operating expense synergies on an annual basis. We’ve also been working to further bolster OCSL’s capital structure post-merger. In the June quarter, we increased the size of our syndicated credit facility to $1.2 billion from $1.0 billion and extended the maturity by two years to 2028 without an increase to the spread that we borrow at 200 basis points over SOFR. We also consolidated a credit facility acquired from OSI2 with our existing Citibank facility and pushed out the maturity by two years to 2027. Most recently, in August, we successfully issued $300 million in senior notes due in 2029.

Together, these transactions improved our funding profile by boosting our unsecured borrowings to 57% and investment capacity to over $1 billion, which allows us to pursue continued growth in the years ahead. 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 economy grew in the calendar third quarter, supported by a strong U.S. job market. However, broader macro conditions remain vulnerable due to the presence of higher interest rates and slowing earnings growth. This is particularly evident in the leveraged credit markets, where we believe investors are increasingly exposed to tail risks. These risks arise as borrowers struggle to service increasingly expensive debt, especially those that are burdened with high costs on floating rate loans, which have become more expensive following the Fed’s aggressive campaign to raise interest rates over the past two years. When we examine this further, we see that many companies, particularly those with outstanding leveraged loans or private debt, borrowed heavily at a time when interest rates were near zero.

As a result, they now have capital structures that may be unsustainable in today’s higher for longer interest rate environment. Importantly, the amount of debt represented by these markets is substantial. Not only have the U.S. broadly syndicated loan and private credit markets grown roughly twofold and sevenfold, respectively, since the global financial crisis of 2008, but the proportion of lower quality debt in these markets has also increased. By the end of the third calendar quarter, loans with credit ratings of B or below represented almost 75% of U.S. leveraged loans compared to roughly 35% prior to the financial crisis. When the weakest segment of the credit markets is both sizable and more vulnerable than usual, investors face a heightened risk of increased defaults and lower than anticipated recovery rates.

If this were to happen, both performing and distressed credit investors are likely to encounter an expanded set of challenges and opportunities. At Oaktree, as we have navigated through many economic cycles, we’ve gained valuable experience that has allowed us to capitalize on opportunities, which is why we are optimistic about what might be ahead for OCSL. Our ample capital and commitment to navigating short-term volatility have been instrumental in our success to-date and of our strategy moving forward. To be sure, we believe caution remains necessary, but we are confident in the resilience of our portfolio that is well equipped to endure any potential economic downturn. This is evidenced by our elevated repayment activity throughout the fiscal year, highlighting the strength of our portfolio.

We expect to continue selectively investing across both the sponsor and non-sponsor backed markets, methodically pursuing attractive opportunities as they arise. Now, turning to the overall portfolio. At the end of the fourth quarter, our portfolio was well diversified to $2.9 billion at fair value across 143 companies. We continue to focus on investing at the top of the capital structure, favoring larger, more diversified businesses to contain risk. 86% of the portfolio was invested in senior secured loans, with first lien loans representing 76% of the portfolio at fair value. Median portfolio company EBITDA as of September 30 was approximately $109 million, and leverage in our portfolio companies was steady at 5x, well below overall middle market-leverage levels.

The portfolio’s weighted average interest coverage, based on trailing 12-month performance was steady at 2.2x. In the September quarter, we originated $87 million of new investment commitments across three new and three existing portfolio companies. All of these originations were first lien, including a $41 million add-on commitment to Keter, an end-to-end recycling and waste managed services company. We also committed $30 million across two prominent application software companies, Forcepoint, a provider of network security, and Finastra, a global financial software company. I wanted to spend a few moments to delve into our approach to lending to the software sector, which now represents 16.5% of our total investments. First, we focus on lending to large enterprise software businesses with mission-critical solutions that deliver significant added value to their customers.

Second, we look for companies with a diverse customer base, reducing their reliance on any single industry and enhancing overall performance stability. Third, we generally partner with a select group of private equity sponsors that have significant domain experience in the sector. And finally, we have deliberately steered clear of the more aggressively priced transactions prevalent in the market in 2021 and 2022. As an experienced investor in this space, we believe that the risk/reward proposition in most of these deals wasn’t favorable. As a result, we passed on all of the software transactions we evaluated from September 2021 through September 2022. As we begin the new fiscal year, our origination activity is steady. We have a strong pipeline of opportunities that we anticipate will fund prior to calendar year-end.

Turning to credit quality. We’ve experienced positive developments in our non-accruals, which declined to 2.4% and 1.8% of the portfolio at cost and fair value, respectively. These improvements were largely attributable to the successful resolution of Athenex, which was fully repaid during the fourth quarter. As you may recall, we placed our investment in this company on non-accrual earlier in the year after it was unable to secure approval of a key prescription drug. We had structured the loan with strong downside protections and held a senior position, which allowed us to secure repayment at par plus accrued interest and fees as the company sold assets and used the proceeds to pay off what it owed to OCSL, resulting in a realized IRR of about 20%.

Another portfolio company, SiO2 emerged from bankruptcy in August. We restructured our investment, which allowed us to place the first lien term loan back on accrual status. However, we did add a new investment to non-accrual status in the quarter. Continental Intermodal Group, a provider of integrated logistics infrastructure and solutions to the oil and gas industry. This investment, which was made just prior to the onset of the COVID pandemic in January 2020, involved the financing from Oaktree to refinance existing debt. Over the past few years, the company has faced challenges related to the evolving landscape in oil and natural gas exploration. Nevertheless, because of structural protections in our loan, OCSL has been repaid on roughly 70% of its original funded amount to-date, and the position had $16 million of fair value as of September 30, 2023.

While the company is exploring options, we felt it was proven to place it on non-accrual status at this time. It is important to note that our overall portfolio is in solid shape, and with each of these non-accruals, we are leveraging Oaktree’s extensive experience and workouts to achieve successful outcomes on behalf of our shareholders. In short, our robust, capital, and liquidity position coupled with the resources of Oaktree give us tremendous confidence in our ability to succeed in the years ahead. Now, I will turn the call over to Chris to discuss our financial results in more detail.

Chris McKown: Thank you, Armen. OCSL delivered another quarter of strong financial performance, finishing the fiscal year 2023 on a high note. For the fourth quarter, we reported adjusted net investment income of $47.8 million or $0.62 per share, up from $47.6 million and consistent with $0.62 per share in the third quarter. The slight increase on a dollar basis was primarily driven by higher adjusted total investment income and lower base management fees, which was partially offset by higher interest expense. Net expenses for the fourth quarter totaled $54.4 million, up $0.9 million sequentially. The increase was mainly driven by $1.5 million of higher interest expense due to the impact of rising interest rates on the company’s floating rate liabilities, and was partially offset by lower base management fees due to a slightly smaller portfolio and continued realization of operating synergies from the OSI2 merger.

As a reminder, we waived $1.5 million in fees during the quarter as part of the OSI2 merger. Now moving to our balance sheet. OCSL’s net leverage ratio at quarter end was 1.01x, down from 1.14x at the end of the June quarter as proceeds from repayments, exits and sales exceeded funded investment activity by $247 million in the quarter. That said, our net leverage continues to be within our targeted range of 0.9x to 1.25x. As of September 30, total debt outstanding was $1.7 billion and had a weighted average interest rate of 7.0%, including the effect of our interest rate swap agreements, up from 6.6% at June 30, due to the impact of higher interest rates. Unsecured debt represented 57% of total debt at quarter end, up from 36% at the end of the prior quarter.

The mix has shifted due to our successful senior note offering in August where, as Matt noted, we raised $300 million of senior unsecured notes due in 2029 at a rate of 7.1%. In connection with the notes offering, we entered into an interest rate swap agreement whereby we received a fixed interest rate of 7.1% and pay a floating rate based on the three-month SOFR plus 3.126% on the entire notional amount of the notes. We view this as a natural hedge against our primarily floating rate assets in the event short-term rates decline down the road. At fiscal year-end, we continued to have ample liquidity to meet our funding needs with total dry powder of approximately $1 billion, including $136 million of cash and $908 million of undrawn capacity on our credit facilities.

Unfunded commitments, excluding the unfunded commitments to the joint ventures were $206 million, with approximately $154 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. Now, turning to our two joint ventures. Our JVs continue to deliver robust performance to OCSL. Together, the JVs currently hold $446 million of investments, primarily in broadly syndicated loans spread across 50 portfolio companies. For the quarter, the JVs generated ROEs of over 15%, a testament to the solid underlying credit quality and the positive impact of higher interest rates on the predominantly floating rate loans. Additionally, we received a $1.1 million dividend from the Kemper JV, which was consistent with the prior quarter.

Leverage at each of the JVs remains generally in line with the prior quarter at 1.2x. During the quarter, we drove down funding costs at our JVs by refinancing the credit facilities in each vehicle. We put in place new three-year facilities with a new lending partner and were able to reduce pricing by 75 basis points SOFR plus 200 basis points. We were pleased with this outcome as it will be accretive to the ROEs of the JVs. In summary, we are very pleased with our financial results for the quarter and the fiscal year, and we continue to believe that our strong balance sheet positions us well for fiscal year 2024. Now, I will turn the call back to Matt for some closing remarks.

Matt Pendo: Thank you, Chris. Our strong financial performance for both the quarter and full-year has enabled us to generate an annualized return on adjusted net investment income of 12.6% during the September quarter and 12.1% for the full-year. Our results have been underpinned by several factors. We’ve been experiencing the benefits of rising interest rates and have had successful investment repayments and sales while maintaining discipline in our capital deployment. Our balance sheet has been strengthened through our recent notes offering, providing us with ample liquidity to invest. And as Chris noted, our joint ventures have excelled, consistently delivering mid-teen returns on equity in the most recent quarter. Looking ahead, we are committed to maintaining our strong performance as we remain disciplined in all aspects of our operations.

Our portfolio continues to be very well-positioned and our robust relationships and deep underwriting expertise equip us to capitalize on any future volatility that might arise in the market. We are proud of our growth in our earnings for the past several years and are confident that we remain very well-positioned to continue delivering attractive returns going forward. 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.

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Q&A Session

Operator: We will now begin the question-and-answer session. [Operator Instructions]. At this time, we will take our first question, which will come from Bryce Rowe with B. Riley. Please go ahead.

Bryce Rowe: Thanks. Good morning. Wanted to start with some of the repayment activity that you noted a bit elevated relative to maybe what we’ve seen over the last — even last couple of years. Could you talk about kind of the nature of the exits? What was prepayment or repayment versus sale? And then, wanted to also ask about the comment you made about kind of seasonality versus selectivity in terms of the origination activity. Hoping you might be able to kind of parse that out for us. Thanks.

Armen Panossian: Sure. This is Armen. I’ll take the second question first. So in terms of seasonality, the summer months were a little bit slow in terms of just activity. I think the rise in base rates that started last year became sort of a reality for folks this year. And so M&A volumes are down materially this year, and that’s why the — I would say the slowdown occurred in the summer months. There also has been a fair portion of technology-related transactions this year with some large tech take privates. But outside of tech, I wouldn’t say that thematically, any one industry has been a big driver of origination in tech, its mainly — the reason deals are still getting done is that there is at least perceived growth for those tech companies and they’re willing to write really large equity checks in those tech deals, 60%, 70%, 80% types of checks, and still be able to underwrite to nice growth for those businesses.

So those deals are getting done. With that said, we do expect a pickup in origination activity back to sort of the upper end of our quarterly origination activity in the last four or five quarters. For the quarter ended 12/31, I hesitate to provide very detailed guidance on that because some deals could fall into January, but we are — we do have a fair number of deals in the pipeline that are expected to fund this quarter that will be meaningfully higher than the originations that we saw in the quarter ended September 30. For guidance purposes though, I would just say that a lot of those originations are going to be happening sort of later in the first fiscal quarter or fourth calendar quarter. So I wouldn’t model a full quarter’s worth of income associated with those, but you will see a pretty big pickup.

In the case of payoffs versus sales, in terms of the exits, most of the $309 million or so of proceeds was from payoffs. About 75% was from payoffs and the rest were from sales. In the case of some of them, it was — there was a life sciences investment. I think a big one was our investment in Jazz acquisition, or Wencor, which is a private equity owned company that got sold to a strategic. So I wouldn’t say thematically there was anything really going on that drove the payoffs, but I think there were just some surprises in terms of repayments. For example, we also got a repayment in our position in Apptio, which was a software name that fully paid off as well. So some chunky payoffs in software, including WP Engine, and then some more idiosyncratic things like the Wencor repayment that occurred upon the sale of that business.

Bryce Rowe: Armen, I appreciate all that detail. I’ll step back in queue. Thanks.

Armen Panossian: No problem. Thank you.

Operator: And our next question will come from Ryan Lynch with KBW. Please go ahead.

Ryan Lynch: Hey, good morning. Thanks for taking my questions. First one I had was with your new unsecured notes that you guys issued. You guys swapped out the rate to a floating rate. You guys have done that in the past. I’m just curious, is that more of a — sort of a rate call given where base rates are today and they kind of better match your portfolio in case rates fall? Or is that something that’s more a policy change where you guys are just going to start swapping out unsecured notes to floating rate and basically have an entire floating rate liability structure?

Matt Stewart: Hi, it’s Matt Stewart. Given the makeup of our asset mix, which is about 90% floating rate, we did it to better match our assets and liabilities. We do have one fixed rate note that’s still fixed to-date, which is our 2025, which is $300 million. And that matches roughly our fixed rate assets on our — on the left side of our balance sheet. But going forward, we’re taking the approach of matching our liability mix. So all of our secured facilities are floating, and then our two — our most recent bond deal, and then our 27s are also floating. So we’re matching our assets and liabilities from that perspective.

Ryan Lynch: Okay. And then, one thing, which was a positive surprise, you guys were able to sounds like lower the spread on your credit facility in your JV by 75 basis points. Should we expect that to flow through to any higher distributions from those JVs going forward?