Oaktree Specialty Lending Corporation (NASDAQ:OCSL) Q3 2023 Earnings Call Transcript

Oaktree Specialty Lending Corporation (NASDAQ:OCSL) Q3 2023 Earnings Call Transcript August 3, 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 Third Fiscal Quarter 2023 Conference Call. Today’s conference call is being recorded. [Operator Instructions] 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 third 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 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 for your interest and support of OCSL. We appreciate your participation on this call. We produced strong results in our fiscal third quarter, bolstered by robust origination activity at attractive yields and the positive impact of higher base rates on our predominantly floating rate portfolio. Combined with the cost synergies arising from the recently closed merger with OSI2, we generated strong earnings on behalf of our shareholders. Third quarter adjusted NII was $0.62 per share in line with the prior quarter. This was supported primarily by higher total investment income and lower operating expenses, partly offset by increased interest expense as well as higher management and incentive fees.

We reported NAV per share of $19.58, down slightly from $19.66 for the prior quarter. The decrease reflected a modest decline in the value of certain debt investments and was offset by net investment income in excess of $0.55 per share quarterly dividend. Given the strong overall earnings, our Board maintained our quarterly dividend at $0.55 per share. As a reminder, this is nearly double our pre-pandemic quarterly dividend run-rate of $0.285. Our investment activity in the third quarter was strong, with $251 million of new investment commitments, more than double the level of the prior quarter. Of the new originations, nearly 90% were private direct lending opportunities and 90% were first lien loans, reflecting our emphasis of being at the top of the capital structure.

The weighted average yield on new originations was attractive at 12.6%. Pay-downs and exits in the quarter were also strong as we received $261 million of proceeds. While broader market activity has been slower given higher interest rates and fewer refinancings, we continued to receive steady levels of pay-downs and have also been opportunistic selling out of lower yielding public credit investments. Importantly, the third quarter marked our first full quarter realizing synergies following the merger with OSI2. We are pleased to be on track to achieve $1.4 million worth of operating expense synergies on an annualized basis. We have also been focused on streamlining our capital structure, leveraging OCSL’s greater scale to improve our financial flexibility.

During the quarter, we increased the size of our syndicated credit facility to $1.2 billion from $1.0 billion and extend the maturity by 2 years to 2028. We also consolidated a credit facility acquired from OSI2 with our existing Citibank facility and pushed up the maturity by 2 years to 2027. We appreciate our banking partners support and their confidence in Oaktree as a manager. These improvements further strengthen our funding options and enhance our ability to capitalize the new investment opportunities. Altogether, our strong balance sheet puts OCSL in excellent shape to continue delivering attractive returns to our shareholders. Before I turn the call over to Armen, on behalf of the team, I wanted to congratulate him on being selected as Co-CEO of Oaktree along with Bob O’Leary, beginning in the first quarter of calendar 2024.

Well deserved Armen.

Armen Panossian: Thanks, Matt. Much appreciated. Good day, everyone. The current market environment presents a complex landscape. On one hand, headline inflation has responded to the most aggressive rate hiking cycle in 40 years. However, core inflation, which excludes food and energy prices, has proven more challenging to control. Meanwhile, unemployment numbers and consumer spending are both relatively stable. Against the backdrop of rapid rate increases, this economic resilience can be at least partially attributed to the U.S. government’s aggressive fiscal policy that has buoyed the economy. In the near-term, investors have become exuberant and the public markets have rallied over the last several weeks. If inflation continues to trend in the right direction and a recession does not occur, the likely scenario would be that rates would remain higher for longer.

Such a condition would create elevated default risk, among interest rate sensitive assets, such as real estate and highly levered equities, even if a recession does not materialize first. Many companies have capital structures put in place during the easy money era of near zero base rates. And we have only recently begun to see the elevated impact of higher rates of levered free cash flow. This might lead borrowers to seek concessions from lenders or additional equity injections from owners. As a result, availability of capital for new deals may become limited at times, benefiting managers like Oaktree, who consider these risks well in advance of them materializing helping our portfolios withstand volatility and capitalize an opportunities.

At OCSL, our timely merger with OSI2 provided us with important scale, and as Matt noted additional financial flexibility. Combined with our team’s long history of opportunistic investing, we believe that we are well positioned to leverage the power of the Oaktree platform and to negotiate and structure deals that provide downside risk protection and generate excellent risk adjusted returns over the long-term. Now turning to the overall portfolio. At the close of the June quarter, our portfolio was well diversified with $2.1 billion at fair value across 156 companies. 88% of the portfolio was invested in senior secured loans, with first lien loans representing 76% underscoring our emphasis on being at the top of the capital structure. We continue to emphasize investing in larger, more diversified businesses that are better positioned to weather downturns on market turbulence.

To that end, median portfolio company EBITDA as of June 30 was approximately $190 million and leverage in our portfolio companies was 5.0x, well below overall middle-market leverage levels. The portfolio’s weighted average interest coverage based on trailing 12-month performance was steady at 2.5x. Turning now to our origination activity, our $251 million of new investment commitments were spread over 6 new and 4 existing portfolio companies in the quarter. I would like to highlight two representative examples from the quarter. First, Oaktree led to direct lending financing from Melissa & Doug, which sells children’s toys to retailers in North America and Europe, known for reimagining classic educational play patterns to promote creativity, imagination and social connection.

The company’s toys encourage free play and reduce screen time, an increasingly popular mission. Oaktree approached the sponsor, who was originally planning to amend and expanded it into existing broadly syndicated loans in the public market and offered several flexible financing solutions. This resulted in an Oaktree led transaction consisting of $260 million first lien term loan and a $65 million revolving credit facility. OCSL has allocated $51.3 million in total and the deal was priced at SOFR plus 750. Second, Oaktree originated a $550 million commitment and allocated $50 million to OCSL as part of a larger loan to Vedanta Group, an India-based diversified resources company. Its presence spans across the zinc and aluminum, oil and gas, copper, power, iron ore and steel industries.

The company was looking to raise capital and refinance debt that was set to mature in the near-term. This first lien loan was priced favorably with a 13% fixed rate and carried strong downside protections. Turning to credit quality, we moved three investments to non-accrual during the quarter, one involved a very small immaterial position with a fair value of $325,000 and other All Web Leads, which provides insurance lead services, is a non-core position we inherited from the prior manager that is maturing later this year. While the company is exploring options, including the possible sale of some or all of its assets, we felt it was prudent to place it on non-accrual at this time. The other new non-accrual is an investment that we made in Athenex, a biopharmaceutical company dedicated to the discovery, development and commercialization of novel therapies in the treatment of cancer and related conditions.

It has many sub-divisions and uncorrelated assets that it has been selling over time to pay-down our loan. Today, OCSL has been repaid on roughly 90% of its original funded amount of $55 million and the position totaled $7.5 million fair value as of June 30, 2023. In May, the company filed for Chapter 11 to facilitate an orderly sale and wind down of the remaining assets, which we expect to conclude in the near-term. To that end, since quarter end, we received an additional pay-down of $2.3 million. Altogether, the new non-accruals represented just 1% and 0.8% of the debt portfolio at cost and fair value, respectively. Importantly, our overall portfolio is in solid shape. With each of these non-accruals, we expect to arrive at successful outcomes on behalf of our shareholders.

In summary, our increased scale and experience across various cycles, paired with the power of the Oaktree platform, places OCSL in great shape to close out fiscal 2023 and move into the next year. Now, I will turn the call over to Chris to discuss our financial results in more detail.

Chris McKown: Thank you, Armen. OCSL continues to deliver consistently strong financial performance, and we have demonstrated that again this quarter. For the third quarter, we reported adjusted net investment income of $47.6 million or $0.62 per share, up from $45.4 million and consistent with $0.62 per share in the second quarter due to the higher share count as a result of the merger with OSI2. The increase on a dollar basis was primarily driven by the first full quarter of interest income earned on the assets acquired in the merger, the impact of higher base rates on the company’s floating rate debt portfolio and lower operating expenses, which were partially offset by higher interest expense, management fees and incentive fees.

Net expenses for the third quarter totaled $53.5 million, up $3.2 million sequentially. The increase was mainly driven by $3.0 million of higher interest expense due to the impact of rising interest rates on the company’s floating rate liabilities and an increase in the average borrowings outstanding. Further contributing to the increase was a $0.8 million increase base management fees, primarily resulting from the first full quarter of the assets acquired in the OSI2 merger as well as $0.6 million of higher Part 1 incentive fees resulting from the higher adjusted net investment income during the quarter. These were partially offset by $1.2 million of lower professional fees in general and administrative expenses, including realized synergies from the OSI2 merger.

With respect to interest rate sensitivity, OCSL remains well situated to further benefit from the increasing rate environment. As of quarter end, 86% of our debt portfolio at fair value was in floating rate investments. Our strong earnings in the third quarter were again driven by the higher base rates as Matt noted. Now moving to our balance sheet. OCSL’s net leverage ratio at quarter end was 1.14x consistent with the end of the March quarter and it continues to be within our targeted range of 0.9x to 1.25x. As of June 30, total debt outstanding was $1.8 million and had a weighted average interest rate of 6.6%, including the effect on our interest rate swap agreement, up from 6.2% at March 31 due to the impact of higher interest rates. Unsecured debt represented 36% of 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 $542 million, including $60 million of cash and $483 million of undrawn capacity on our credit facilities. Unfunded commitments, excluding unfunded commitments to joint ventures were $247 million, with approximately $185 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. With respect to our credit facilities during the quarter, we entered into an amendment to our syndicated credit facility that among other things increased the size of the facility from $1.0 billion to $1.2 billion and extended its maturity by 2 years to June 2028 with no change in the margin.

There are now 20 lenders in the syndicate. Also, during the quarter, we consolidated the OCSL and OSI2 SPV facilities with Citibank, entering into a new $400 million facility that matures in 2027. Shifting to our two joint ventures. At quarter end the Kemper JV at $370 million of assets invested in senior secured loans to 52 companies down from $393 million last quarter, primarily as a result of exit exceeding new originations. The JV generated $3.4 million of cash interest income for OCSL in the quarter, up from $3.2 million in the second quarter as a result of the portfolio’s continued strong performance in the impact of rising interest rates on floating rate investments. We also received a $1.1 million dividend consistent with the second quarter dividend.

Leverage at the JV was 1.2x at quarter end, down from 1.4x in the prior quarter. The Glick JV had $127 million of assets as of June 30, down from $131 million at March 31. These consisted of senior secured loans to 38 companies, leverage at the JV was 1.2x times at quarter end, and we received $1.7 million of principal and interest payments on OCSL subordinated note in the Glick JV during the quarter. In summary, we’re very pleased with our financial results. And we continue to believe that our strong balance sheet positions as well for the remainder of the fiscal year. Now I will turn the call back to Matt for some closing remarks.

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 12.6%. Consistent with the prior quarter, we are very pleased with the growth in our earnings over the past several years, and believe that OCSL remains well positioned to continue delivering strong ORE going forward. First, we believe we are well situated for the prevailing higher interest rate environment. As Chris noted earlier, with 86% of our investment portfolio in floating rate assets, we expect that the July rate hike in future potential increases in base rates will positively impact our net interest margin. We also continue to benefit from higher ROE is generated at our joint ventures.

During the third quarter, both joint ventures delivered ROEs of over 14.5% due to strong credit quality and positive impacts from the rising rate environment. As noted earlier, we expect that the synergies resulting from the OSI2 merger will support our returns and generate substantial long-term value for our shareholders. In conclusion, we are very pleased with the continued strength in our results in our ongoing momentum. Our portfolio is diverse and healthy, and we are in excellent financial shape to capitalize on this volatile but attractive investment environment. With our robust liquidity, extensive relationships and disciplined underwriting expertise, we believe that our solid portfolio and strong balance sheet position us favorably for the remainder of the fiscal year.

As always, we thank you for joining us on the call today and for your continued interest in OCSL. With that, we’re happy to take your questions. Operator, please open the line.

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Q&A Session

Operator: Thank you. [Operator Instructions] Our first question comes from Erik Zwick from Hovde Group. Erik, please go ahead.

Erik Zwick: Good morning. Thank you. I wanted to first just start – you had a very strong quarter in terms of new commitments, I am curious what that might mean for the pipeline going forward. And then the next quarter or so if you are seeing similar strong opportunities at this point.

Armen Panossian: Hi, Eric, it’s Armen. Yes, it has been a strong quarter in terms of originations, what you do see in the quarter represents originations that have been in the pipeline now for at least a quarter if not two or three. And so there is a little bit of a lag in terms of the actual originations that you see in any particular quarter, I would say that, generally speaking, the next quarter, the September quarter ended September 30, will probably be a little bit lighter, just given the fact that the elevated cost of borrowing, base rates have risen so much and spreads have widened, has caused a bit of a decline in M&A volume, as well as a little bit of a pause button being hit by non-sponsored transactions or non-sponsored investment opportunities that we’re considering as well. So I am expected to be a little bit lighter over the next quarter or so.

Erik Zwick: Thanks. That’s helpful. And then Armen, in your prepared comments, you mentioned that the higher for longer rate environment can create elevated default risk. And I know you typically try and focus on kind of more conservative and just kind of defensive portfolio, but you have the opportunity to look across a broad number of sectors. So I’m curious, at this point, are you seeing any signs of weakness or concern in any particular sectors? Or is it still kind of too early at this point to see how that might play out?

Armen Panossian: It’s a good question. So we are, I wouldn’t say that we’re seeing huge alarm bells at the moment. But certainly, the stresses, the early signs of stress, I would say, are most acute in companies that didn’t benefit from COVID and have experienced some inflationary impact in their costs. So healthcare services, transactions of an older vintage that are in healthcare services, I would say are showing a little bit more stress than the average borrower use some technology companies are, I think, seeing some stress and they are working on their cash flow generation potential, I think a lot of technology companies are actually focusing on generating cash flow or becoming cashflow neutral, because the assumption of having access to the capital markets has gone away a bit.

And so you are probably more likely to see stress in some technology oriented companies versus the average borrower as well. But net-net I think it is a bit early to really tease out an industry or sector specific trend.

Erik Zwick: That’s great color. Thanks for taking my questions today.

Operator: And we now have a question from Melissa Wedel from JPMorgan. Melissa, please go ahead.

Melissa Wedel: Good morning. Thanks for taking my questions today. Following up on the new activity in the portfolio, I was just curious, was there anything kind of idiosyncratic around timing of new deployments versus repayments during the quarter? I guess more specifically, did you see repayments earlier in the quarter and put capital to work later?

Armen Panossian: Hi, Melissa, it’s Armen, again. I don’t think that there was any discernible trend that way in terms of timing. I think we were fairly active in originating throughout the quarter, we had a couple specialty loans that were done in partnership with our opportunistic credit group that it’s hard to predict if they closed in a certain week or a certain month, they just take longer to document. And so I wouldn’t say that there was any sort of trend in that regard.