Blue Owl Capital Corp Q1 FY2022 Earnings Call

Good morning. My name is Rob, and I will be your conference operator today. At this time, I would like to welcome everyone to the Owl Rock Capital Corporation's First Quarter 2022 Earnings Conference Call. All lines have been placed on mute to prevent any background noise. After the speakers’ remarks, there will be a question-and-answer session. Thank you. Dana Sclafani, Head of Investor Relations. You may begin your conference.

Thank you, operator. Good morning, everyone, and welcome to Owl Rock Capital Corporation's first quarter earnings call. Joining me this morning are our Chief Executive Officer, Craig Packer, our Chief Financial Officer and Chief Operating Officer, Jonathan Lamm, and other members of our senior management team. I'd like to remind our listeners that remarks made during today's call may contain forward-looking statements, which are not a guarantee of future performance or results and involve a number of risks and uncertainties that are outside the company's control. Actual results may differ materially from those in forward-looking statements as a result of a number of factors, including those described in ORCC's filings with the SEC. The company assumes no obligation to update any forward-looking statements. We will also be referring to non-GAAP measures on today's call, which are reconciled to GAAP figures in our earnings press release and supplemental earnings presentation available on the Investor Relations section of our website at owlrockcapitalcorporation.com. With that, I'll turn the call over to Craig.

Thanks, Dana. Good morning, everyone, and thank you for joining us today. First, let's cover our high-level results. Our net investment income was $0.31 per share, in line with our previously declared first quarter dividend. We also reported net asset value per share of $14.88, down modestly from our fourth quarter NAV per share of $15.08, primarily driven by market credit spread widening. This quarter was clearly an inflection point in the economy and in the credit markets. Investor concerns around geopolitical uncertainty, inflation, and the shift in Fed policy led to increased volatility across the broader market. Despite these developments, we are very pleased with our performance and how our portfolio is positioned for the evolving economic environment. This was our third consecutive quarter of covering our dividend, but it was a notable one, because we were able to generate $0.31 per share of NII despite very little repayment income, primarily due to a seasonally quieter M&A environment in the first quarter. Repayment related fee income was a meaningful contributor to our results in the last two quarters, given how active the deal environment was in the second half of 2021. During the quarter, we originated primarily first lien investments at attractive spreads, and we continue to optimize our portfolio mix. We were able to redeploy capital from lower spread repayments into higher spread new originations, while still maintaining roughly 75% of our assets in first lien or unitranche term loans. We finished the quarter with a $12.8 billion portfolio across 157 investments, which continues to generate healthy interest and dividend income. We believe our NII this quarter demonstrates the strong core earnings power of our portfolio, even without significant fee income. In addition, we would expect to see further benefits from rising rates and an increase in repayment income, as deal activity rebounds in the second half of the year. For some perspective, a year ago, in the first quarter of 2021, our NII was $0.26 per share. Since that time, we have significantly grown the portfolio and increased leverage to within our target range, which drove an almost 20% increase in NII year-over-year. We are also pleased with how well our portfolio is performing despite recent macroeconomic challenges. From the effects of the pandemic in 2020 to the current impact of supply chain disruptions and rising costs, the performance of our borrowers has been resilient. And while we continue to monitor the portfolio closely, we expect it to continue to perform well. The portfolio is well diversified and our internal ratings remain largely consistent. We continue to have only one company on non-accrual status, representing 0.1% of the portfolio based on fair value, one of the lowest levels in the BDC sector and our annualized loss ratio remains very low at roughly 15 basis points. We believe this performance reflects the quality and long-term orientation of our investment process. Since inception, we have invested in non-cyclical service-oriented businesses with enduring revenue models. These businesses have historically been less impacted by issues such as supply chain disruption, and have performed well in various market cycles. As of quarter end, more than half of our portfolio companies were in service-oriented sectors, such as software, insurance, financial services, and healthcare where customer demand, sales and margins have remained strong. While we certainly have select credits experiencing some cost pressures due to labor, freight, or commodity prices, many of our borrowers are leaders in their markets, which often allows them to pass many of these costs on to their end customers through price increases. While they may experience a temporary lag, by and large, we expect most of our companies to be able to manage through the current environment as well. We are also focused on how a rising rate environment will impact our borrowers as we enter a Fed tightening cycle. The large majority of our borrowers are entering this environment from a position of strength with an average interest coverage ratio of 2.7 times. We also take comfort that our average loan-to-value in the portfolio is approximately 45%, giving us ample cushion in a downside scenario. We are closely monitoring the impact of increased borrowing costs on our borrowers but we expect they will be able to maintain comfortable cushions even as rates increase as expected. We believe the tailwinds of the strong US economy will continue to support the businesses in our portfolio and based on our discussions with borrowers, they are well-prepared to adapt quickly and respond to evolving market conditions. With that, I will turn it over to Jonathan to discuss our financial results in more detail.

Thank you, Craig. We ended the first quarter with total portfolio investments of $12.8 billion, outstanding debt of $7.2 billion and total net assets of $5.9 billion. Our NAV per share was $14.88, down modestly from the fourth quarter, reflecting a decline in the fair value of our portfolio due to the impact of wider credit spreads in the market. With the portfolio now fully invested, we will continue to redeploy capital from repayments into new investments. In the first quarter, we had $375 million in repayments and roughly $350 million in new funded investments. As a result, net leverage was largely unchanged at 1.17 times debt-to-equity and remains comfortably within our target range. We also ended the first quarter with liquidity of $1.7 billion. Turning to the income statement, our net investment income was $0.31 per share, in line with our previously declared first quarter dividend. For the second quarter of 2022, our Board has again declared a $0.31 per share dividend payable on August 15 to stockholders of record on June 30. Our total investment income for the quarter was $264 million versus $282 million in the fourth quarter, reflecting lower fee-related income. Total expenses at $141 million also declined versus the previous quarter, due to lower interest expense and incentive fees. Turning to our balance sheet, we have been focused on the transition from LIBOR to SOFR on both our assets and liabilities. On the asset side, most new investments are being priced on a SOFR basis and we expect to transition existing assets in normal course discussions until June of 2023. On the liability side, all new facilities are being priced on a SOFR basis and we are making good progress, transitioning our existing facilities as well. I'd also like to spend a minute on how we expect rate increases to impact ORCC. We expect to benefit materially from rising rates in the second half of the year. As I discussed last quarter, once rates rise through the floors on the asset side, and are reflected in our borrowers' interest rate elections, we expect investment income to increase meaningfully. LIBOR started the year at 21 basis points and increased roughly 80 basis points over the course of the first quarter. The majority of our borrowers have 100 basis point floors, so this increase did not benefit our interest income in the first quarter. The majority of our borrowers also reset their borrowing rate quarterly at the end of each calendar quarter. Further, as LIBOR was at roughly 100 basis points at the beginning of April, we expect the benefit to interest income to be limited in the second quarter. As LIBOR has continued to rise in the second quarter and based on our observation of the forward curve, we do expect rising rates to benefit interest income in a more material fashion, once borrowing rates reset for the third quarter. On the right side of our balance sheet, taking into account our equity and our fixed rate liabilities, only 29% of our capital will be negatively exposed to rising rates. Our floating rate liabilities typically have 0% floors. Therefore, these liabilities will have higher interest expense in the second quarter. To summarize, given almost all of our assets are floating and only 29% of our capital structure is floating, we expect rising rates may have a slightly negative impact in the second quarter, but will result in a meaningful net positive impact on NII starting in the second half of 2022. For example, all else equal, a 100 basis point rate increase would generate approximately $0.04 per share in quarterly NII after considering the impact of income-based fees. With that, I'll turn it back to Craig for closing comments.

Thanks, Jonathan. To close, I would like to provide some commentary on our positioning and current outlook. We're pleased with how ORCC is positioned for the balance of 2022. While we expect repayment activity to remain muted in the second quarter, we believe a combination of rising rates and an expected increase in repayments will be very beneficial in the second half of the year. We feel we have constructed a portfolio built to withstand periods of economic challenges like those we're experiencing today. The portfolio is well-diversified by geography, sector and is short. And our largest investment, representing just 3% of the portfolio's total fair value. In addition, the vast majority of our investments are supported by meaningful equity cushions as evidenced by conservative LTVs across our portfolio. Most of our borrowers are US-based, which generally insulates them from global macroeconomic pressures. The US economy is now larger than pre-pandemic levels. Consumer spending remained strong. The unemployment rate in the US is near record lows. These trends are reflected in the performance of our borrowers, which continue to see EBITDA growth. We also benefit from the scale of our borrowers with a weighted average EBITDA of $145 million across the portfolio. Their size and market-leading positions often allow them to pass on most cost increases from inflation and wage pressure to their customers, which helps our borrowers to maintain margins and profitability. Private equity firms have roughly $1 trillion in dry powder available to deploy at an all-time high. Increased volatility in the public markets is prompting large sponsor-backed take-privates of high-quality companies, particularly in the software sector, where we have significant expertise. We are seeing an acceleration of larger deals getting executed in the private market instead of the public markets which plays directly to our strengths. Today, our dedicated direct lending platform has $45 billion in assets under management and a team of over 90 investment professionals. We believe that as a result of this scale, we remain a lender of choice for sponsors and a trusted financing partner, especially on their largest transactions. Despite the seasonally slow quarter, we reviewed more than 300 transactions across the platform in Q1, an increase of approximately 7% compared to a year ago. The Owl Rock platform originated a total of roughly $5 billion of investments, $3 billion more than this time last year. We also saw a notable increase in the number of large unitranche transactions. In the quarter, we sourced over 20 transactions over $1 billion in size nearly five times the number we saw in the first quarter of last year. We committed to almost half of these opportunities and believe they represent a very attractive combination of credit quality, economics, and structure. Owl Rock has already been publicly named as a lender on several of these deals, including the buyouts of Anaplan and SailPoint and the acquisition of Datto by Kaseya. To conclude, we recognize the macro environment is changing. We're pleased to be entering this environment from a position of strength, and we have intentionally designed our portfolio to generate healthy returns through the entire market cycle. We also believe we're well-positioned to capitalize on the trends benefiting direct lenders, many of which are accelerating because of the volatility the market is experiencing. We are excited about the opportunities we expect this market to generate and look forward to leveraging our competitive advantages in this environment for our shareholders. Thank you all for joining us today. Operator, please open the line for questions.

And your first question comes from the line of Mickey Schleien from Ladenburg. Your line is open.

Yes, good morning everyone. Hope you're well. Craig, I want to ask you about your outlook for spreads. We're in an environment where short-term rates are going up very sharply. And I'm curious, when you think about the supply demand balance or imbalance in the private lending market, whether you think lenders will keep that, or are they going to or will we see spreads come down in order to help close some deals?

Sure. Thanks Mickey. There's obviously a lot of factors that go into spread competition amongst lenders, supply of deals as you referenced. Another very important factor is the health of the syndicated markets, particularly where we play in the upper middle market deals, sponsors are often comparing direct lending solutions versus what they can get in the syndicated markets. Right now, the syndicated markets are experiencing a period of disruption, the high-yield market loan market. And as a consequence in periods like that, the banks tend to pull back from their underwriting and so the direct lending solutions look more attractive, and that's what we're experiencing now. So, I think that it will be an attractive environment for spreads. I don't see spreads contracting I'm hopeful they will widen, but I don't think that they will contract because in a period of volatility in the public markets, particularly with larger deals coming into the direct lending market, we think that's a time to push for a premium on spreads. Now, we have to compete for attractive deals, but my sense is other lenders right now would feel in a similar way. So, I'm hopeful that spreads will widen and I don't think they will contract.

Thank you Craig. One follow-up question, if I can. Given your experience in the credit markets and considering that defaults are extremely low across the table. They can really only go up from this point. But can you give us some sense of where you think defaults could climb in the course of the next couple of years, considering where we are in the economic cycle?

Well, we've had a really exceptional performance in our portfolio with respect to defaults essentially, we've had two in our history and across our platform. We've had a five basis point loss rate and at ORCC, it's a 15 basis point loss rate. So while we can't underwrite to perfection, my expectation is that we're going to continue to have extremely low default rates measured in the low single-digits. Across the leveraged finance space, I think that number will be higher, but I think that it's going to be sector-specific if you think that we are going many are concerned about a cycle over the next two or three years, given what's going on with rates. And if you believe that there's going to be a cycle, then defaults will go up as you are pointing out, but I would expect those defaults to be concentrated in the portions of the economy that are most cyclical. And we can all easily predict homebuilding and metals and chemicals and energy, these are the classic cyclical sectors. I mean those are sectors that we have little to no participation in. So I expect our default rates to remain extremely low. But in the overall leveraged finance base, if defaults climb to mid single-digits, that wouldn't surprise me in the course of the cycle, but they'll be higher in certain sectors.

Yes. I understand. That’s it from me this morning. Thank you for your time.

Thanks, Mickey.

Your next question comes from the line of Robert Dodd from Raymond James. Your line is open.

Hi, everyone. Regarding the unit trends you mentioned, you noted your commitment to half of the $20 billion-plus in unit trades. Can you provide more details about the three software and recurring revenue deals you referred to? How much of your incoming pipeline and potential funding will be focused on those types of deals in the near term, and what percentage of the portfolio are you comfortable underwriting?

Hi. Not every software deal operates on a recurring revenue basis, so they can't be assumed to be the same. While many are, signing a software deal doesn't guarantee it's a recurring revenue deal. When we evaluate recurring revenue deals, they initially have a recurring revenue covenant that measures revenue, providing strong protection for creditors. Over time, typically within two to three years, these arrangements transition to EBITDA-based covenants. Therefore, this isn't a fixed concept. If you're inquiring about the expected proportion of recurring revenue deals in our portfolio, it’s currently around 10%, which is a relatively small segment. These recurring revenue deals are still among the most appealing loans in the market, offering the lowest loan-to-value ratios, robust credit protections through covenants, and greater spreads. They are often backed by companies that experience significant and consistent growth, thanks to high contractual renewal rates. We are keen on these deals and will pursue them for suitable companies, although the opportunities are limited. While we are pleased with the growth of recurring revenue deals for high-quality firms, our biggest sector is only around 12% to 13% of our overall portfolio, making it a modest component.

I appreciate that. Thank you. And one more question, if I may. Wingspire, you committed to invest a significant amount of capital. Can you provide any insights on that, suggesting that demand in that segment is quite strong as well? Is there any specific driver behind this? Also, the dividend has increased nicely from them. What is the outlook for potentially allocating more capital to Wingspire?

We are very pleased with the growth and success at Wingspire. This initiative, incubated at ORCC, has seen the team excel in establishing an exceptional asset-based lending business. We were optimistic about its potential for success from the beginning, and it is gratifying to see it now generating attractive returns and allowing us the opportunity to invest additional capital. We are committed to supporting the Wingspire team in their growth, and we have pledged $350 million, of which approximately $275 million has already been funded. We are open to increasing our investment to make Wingspire a significant part of ORCC's portfolio, with careful consideration of investment opportunities. If we can allocate an additional $150 million to $200 million to Wingspire over the next year, we would be pleased, as it could contribute an extra $0.01 or so to our quarterly net investment income. Given the current economic environment, which may pose challenges to financing, we believe this could drive borrowers towards asset-based lending solutions that Wingspire offers. We also took a more substantial dividend from Wingspire recently, with the first one being modest and this latest one being larger. However, the dividend amount can fluctuate based on Wingspire's performance, and this quarter's amount might be higher than what we expect for the year. We anticipate Wingspire could generate around $20 to $30 million in dividends for ORCC annually, and we would be pleased to see that increase with further equity investments.

I appreciate it. Thank you.

Thanks, Robert.

Your next question comes from the line of Finian O'Shea from Wells Fargo Securities. Your line is open.

Hi, everyone. Good morning. Looking to see if you can add a little color on the market valuation impact across the portfolio. Just looking, you have pretty consistent new origination yields, you have stable credit and historically, liquid marks haven't really had an impact if you agree with that. So has anything changed in the valuation regime, or is there another element I'm missing perhaps that just what led you to take more conservative marks this time?

Paul, I'll start and Jonathan can add in. There has been no change to our valuation process. We have worked with an external valuation firm since the beginning to assess every asset in the portfolio on a quarterly basis, and this valuation is approved by the Board of Directors. While the management team provides significant input and maintains regular communication with the valuation firm, we consider our process to be top-tier for our shareholders. This year, the firm followed the same process as always. Throughout every quarter since our inception, market spreads have played a key role in this evaluation. When spreads compress, the value of our loans increases; conversely, when spreads widen, as we saw in the first quarter, the value of the loans decreases. The decline this quarter was modest, and it follows a consistent trend. We experienced a quarter where spreads in the credit markets widened. These changes contribute to unrealized markdowns, but the overall credit quality in our portfolio remains very strong. Therefore, we anticipate that the loans marked down this quarter due to widening spreads will eventually be repaid at par, at which point we will see a move back to par value. You shouldn’t interpret this process negatively, nor should it reflect poorly on the credit quality, which continues to be excellent.

It's helpful to follow up on that. While one quarter doesn't capture the entire picture, your new origination spreads this quarter stand at 6.5%, down from 6.8% last quarter. This seems consistent, suggesting it's not just the overall direct lending market that's affected. Perhaps there are specific sectors experiencing notably wider spreads in direct lending.

We don't solely focus on direct lending spreads; we also consider all credit spreads, including those in the public loan and bond markets. The public loan market is quite transparent, and we've observed widening spreads there. These elements are factored into our evaluations. It's important to note that every quarter can have fluctuations, so when spreads decrease, prices tend to rise, and when spreads increase, prices typically fall. This quarter, our origination was modest, with $650 million compared to $680 million, which isn't a large enough sample for a direct comparison. However, in the first quarter, we did see a slight widening in direct lending spreads to 6.5%. Again, due to the small sample size, I wouldn't rely on this comparison with the fourth quarter as a definitive market trend. This is reflected in the first quarter's results in both the direct lending and broadly syndicated markets, contributing to a decline in portfolio marks.

Thank you for the information. I have a follow-up question regarding the direct lending verticals. The software group has made significant progress and now has its own BDC complex. You've performed quite well in that area. Do you consider this to be a unique opportunity, or are there plans for additional specialized or dedicated origination verticals within direct lending?

We recognized five years ago the potential to expand our focus in the technology space, especially in software, and we made significant investments in those initiatives and the team. We believe we are one of the largest direct lenders in the technology sector, which provides us a substantial advantage when major deals arise, as we've seen this quarter with public-to-private transactions. Sponsors prefer to collaborate with those who have expertise, understand the credits, can write large checks, ask insightful questions, and operate efficiently. This capability positions us well in these large transactions. We're also exploring other sectors that may offer similar opportunities; healthcare, for example, has always been an active area for us, and we have bolstered our team there. We are considering multiple avenues to enhance our unique expertise. I believe this is the direction private credit will take in the coming years, particularly for firms of our scale that can invest in these resources, which aid in sourcing opportunities and making sound underwriting decisions. We're actively evaluating this. While I won't disclose all potential areas of interest on this call, we are consistently looking into further areas of exploration, including specialty finance verticals like Wingspire. We intend to pursue more opportunities and keep you updated on our progress in these directions.

Great. Thank you so much.

Thank you.

Your next question comes from the line of Kevin Fultz from JMP Securities. Your line is open.

Hi, good morning and thank you for taking my questions. Looking at Slide 5 of the presentation, the average new investment equipment for new portfolio companies was roughly $22 million, which is down meaningfully from recent quarters. Just curious if there's anything to read into there about where you're currently finding attractive new investment opportunities.

Sure, so now that the portfolio is fully invested and are comfortably in our target leverage range, our appetite for new investments in any one quarter is really going to be driven by repayments. And so in periods like this quarter where we saw really light repayments, the new investments were really sizing about to the pace of repayments, give or take. Obviously, you can't do it perfectly. And so you're right to observe that the average investment size was smaller because we just didn't have a lot of capital to deploy and generally tries to have our funds participate in each deal even if that bite-size might be particularly small. So it was simply a quarter where our investment appetite in ORCC was low in aggregate and we did see a lot of deals. Our platform was quite busy. So ORCC participated regularly in the deals that we were underwriting in the platform but the bite size was small to have just a position in those investments. So you're going to see some small line items which are a tiny piece of a much larger deal that we're doing across our platform. Part of the reason we do that is because in the future, those companies now are an incumbent lender. Those companies likely will come back to Owl Rock for additional capital – and at that point, that might be a period where ORCC has more capital to deploy. And so as having a position within the credit, they can then upsize that if they didn't participate at all now, we don't – that likely would not be the case. So some modest-sized positions. So nothing to read into view on the opportunity set is really driven by just a modest quarter for repayments.

Got it. That makes sense, Craig. And then you talked about an expectation for spread widening in the current environment. Just curious if you're seeing any sort of improvement from a documentation standpoint?

I believe I expressed an expectation for spread widening, along with hope for stability, but definitely not a tightening. Our documentation for direct lending remains very strong, which is something we prioritize. Our team dedicates a lot of time to it, and we consistently maintain robust documentation across all relevant credit metrics. This is especially true when financing larger companies, where there is more covenant light in the market. I recognize that as we're lending to companies with $3 billion, $4 billion, or $5 billion in size, they require a level of flexibility that differs from smaller firms with $20 million of EBITDA. However, this flexibility does not compromise our creditor protections; we do not permit asset stripping or substantial dividends or layering. Overall, we appreciate the documentation we receive, and through direct lending, we gain extensive access to the companies and regular updates. From this perspective, I believe the lending environment remains consistently positive.

Okay. Great. I’ll leave it there. And congratulations on the quarter.

Thank you.

And your next question comes from the line of Kenneth Lee from RBC. Your line is open.

Hi. Good morning. Thanks for taking my question. Just a follow-up on the previous question there. Should we interpret that at originations are going to largely match the debt pay down activity. Should we interpret that to say that you're thinking that leverage could remain at current levels, or do you think leverage could change over the near term, just given the current environment? Thanks.

We have set a leverage target of 0.9 to 1.25, which we believe is optimal for balancing shareholder returns with the interests of our lenders, bondholders, and rating agencies. We are currently slightly above the midpoint of this range, which is where we would like to stay. Repayment amounts can vary significantly from quarter to quarter. For this quarter, the repayments were modest and easy to manage, but there may be quarters when repayments are more substantial, allowing for more noticeable movements within the leverage range. Overall, we aim to maintain our leverage towards the upper half of our target range while matching origination with repayments. This is what we believe is the appropriate position for the company.

Great. Very helpful. And just one follow-up, if I may. In terms of the recent large software financing transactions, you highlighted, do you think those recent deals were indicative of any change in market trends, or is this simply a continuation of what you've been seeing for quite some time in terms of large companies utilizing direct lending and directly just taking share from some other players? Thanks.

I believe we're seeing a continuation, or perhaps even an acceleration, of trends we've observed. There are two factors at play: the public equity markets are experiencing increased volatility, which is pushing prices down. On the other hand, private equity firms, sitting on over $1 trillion in capital, are finding significant opportunities to invest as equity valuations decline. This decline allows them to pursue public to private transactions involving attractive companies that were previously beyond their reach or not being considered for sale. As these companies reconsider their position due to lower market prices, private equity firms can step in, utilize their capital, and implement value creation strategies with each acquisition. Simultaneously, amid the volatility of the public credit markets, these firms are increasingly comfortable partnering with direct lenders for larger deals. In recent years, many private equity firms have shifted to direct lending, favoring it over previous financing methods due to the benefits of certainty, speed, confidentiality, and customization that we offer. Our business model, which includes a dedicated software fund, enables us to provide sizable financing that was once only available through public markets. We've developed our team to better support these needs, leading to a noticeable acceleration in this trend, which is evident early in 2022 and continues to evolve. Opportunities from sponsors interested in similar transactions are emerging weekly, reinforcing my positive outlook for ORCC. While there is competition and discussions about spread contraction, those large deals necessitate a variety of lenders to secure financing for commitments of $2 billion to $4 billion. This scenario allows us to charge slightly more, creating a favorable environment for our operations. I anticipate this acceleration of trends will persist throughout the year.

Great. Very helpful. Thanks, again.

Thank you.

And there are no further questions at this time. Mr. Craig Packer. I turn the call back over to you for some final closing remarks.

All right. Terrific. I appreciate everybody's time. And look forward to speaking with you. If you have any follow-up questions on anything about our company, please reach out. We enjoy engaging with you, and we'll speak with you soon. Thank you.

This concludes today's conference call. Thank you for your participation. You may now disconnect.