Earnings Call Transcript - OBDC Q1 2023

Dana Sclafani, Head of IR

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 Lam; 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 the 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. Certain information discussed on this call and in our earnings materials, including information related to portfolio companies, was derived from third-party sources and has not been independently verified. The company makes no such representations or warranties with respect to this information. ORCC's earnings release, 10-Q and supplemental earnings presentation are available on the Investor Relations section of our website at owlrockcapitalcorporation.com. With that, I'll turn the call over to Craig.

Craig Packer, CEO

Thanks, Dana. Good morning, everyone, and thank you all for joining us today. We are pleased to report another quarter of very strong results, driven by continued growth in earnings and strong credit performance. Our net investment income for the first quarter was $0.45 per share, a $0.04 increase from the prior quarter and a $0.14 increase compared to a year ago. This is a new record quarterly NII for the company. I want to start by putting this strong quarter in context. Going into the third quarter of last year, we were confident that rising rates and continued credit performance were going to drive significant improvement in earnings. As a result, we increased our regular dividend by $0.02 and added a formulaic supplemental dividend to our quarterly dividend structure. We recognized that we would significantly outperform the regular dividends in a rising rate environment and wanted to create a predictable mechanism to share that upside with shareholders. Compared to the second quarter of 2022, the average base rate in the portfolio increased roughly 300 basis points and the NII has grown by over 40%, which has driven the growth in our supplemental dividend. For the first quarter, our Board approved a supplemental dividend of $0.06 per share, an increase of $0.02 from the prior quarter. This is in addition to our previously declared $0.33 regular dividend which results in total dividends of $0.39 for the quarter. In total, this represents an annualized dividend yield of over 12% based on the current share price, which we believe is very attractive in today's market. We also delivered an ROE of 12.1% for the quarter, and we would expect to deliver an ROE in excess of 12% over the full year based on our current outlook for rates and credit performance. Our continued earnings growth is complemented by the strength of our portfolio. Net asset value per share increased to $15.15, up $0.16 or 1% from the fourth quarter. The majority was driven by over-earning our dividend by $0.08 and by roughly $0.08 of net realized and unrealized gains in the portfolio. The average mark on our debt positions this quarter increased to 97.6% from 97% last quarter. However, the primary driver of this change was the improved marks on certain debt investments which were restructured during the quarter. Excluding those, the average change in the mark on the remainder of the debt portfolio was roughly 15 basis points. We also benefited from the increase of the mark in the equity investment in our senior loan fund, reflecting improved public market loan trading levels. In addition to higher rates, our results were driven by the strength of our credit quality, which is reflected in our very low nonaccrual rate, which stands at just 0.3% of the fair value of the portfolio with only 2 names on nonaccrual as of quarter end. We are very pleased with these results and believe we are in a position to maintain this level of earnings power and credit performance in today's environment. That said, we continue to expect and are prepared for more challenging conditions in the back half of the year. Like many in the market, we have been anticipating a shift in consumer demand on the back of the higher rate environment and a subsequent contraction in the economy. We remain vigilant and are proactively analyzing our portfolio. Similar to last quarter, we have not yet seen any early signs of challenges across our borrowers who continue to deliver stable operating performance. Revenue and EBITDA are growing at a modest, albeit slowing pace. Many of our borrowers are experiencing improved profitability as a result of receding supply chain disruptions and lower input costs. We also take comfort that our portfolio is primarily comprised of senior secured first lien investments with low loan-to-values across companies that have strong financial sponsor backing. We are closely monitoring the interest coverage levels of our borrowers. As we expected, reported interest coverage continued to decline, finishing the quarter with a weighted average coverage ratio of 2.2x. We fully recognize that the current rate environment, as it works its way through borrowers' financials, will reduce interest coverage levels over the course of the year. We believe average interest coverage on our portfolio will trough around 1.5x in the second half of this year. This will undoubtedly pressure liquidity at some borrowers more than others. However, we believe we have good visibility into the small number of borrowers, which could be most affected, and therefore, we think that these challenges will be manageable. Further, as we've said before, most of our borrowers benefit from financial and operational support from sophisticated financial sponsors. Sponsors are also preparing for a tougher environment later in the year, and we've seen sponsors positioning the companies more defensively. This includes cutting costs, putting projects on hold and shoring up liquidity. Lastly, when these situations do get more stressed, we have the tools in place to ensure that we are in dialogue early and often with borrowers and their sponsors. This information flow and our strong documentation and covenant protections ensure that we have a seat at the table at the early signs of trouble. We can then work with the sponsors who are generally incentivized to put in additional capital to provide near-term support in order to protect the longer-term value of their investment. For these reasons, we believe we are well prepared for further challenges to come. As we said before, while we may see increased levels of stress, we believe defaults or potential losses will be manageable and will be more than offset by the continued strength of our earnings across the balance of the portfolio. We are proud of the highly diversified and well-insulated portfolio we have built. Our borrowers have the advantages of size, scale and sponsor support as we enter a potentially more challenged environment, and we believe this will serve us well. With that, I'll turn it over to Jonathan to provide more detail on our financial results.

Jonathan Lam, CFO and COO

Thanks, Craig. We ended the first quarter with total portfolio investments of $13.2 billion, outstanding debt of $7.4 billion and total net assets of $5.9 billion. Our NAV per share was $15.15, a 1% increase from our fourth quarter NAV of $14.99. This increase was driven by the continued strong performance of our borrowers and our continued over-earning of the dividend. We continue to see the impact of the broader slowdown in M&A and refinancing activity on new investment activity across the market. Funded activity for our portfolio remained modest at roughly $94 million, which reflects the low repayment activity we continue to see. Turning to the income statement. We are pleased with the continued strength of our earnings. We believe this quarter's NII represents a sustainable level in the current rate environment. We could see further upside if repayments pick up or dividend income from our strategic equity investments and the senior loan fund increase. Conversely, we could also see a decline in NII if rates drop or non-accruals increase, although we do not currently see evidence of either happening in the near term. As a result, we believe that we will be able to deliver ROE in excess of 12% for the year and provide attractive dividend income to our shareholders. We have also continued to work towards our previously announced repurchase target of $75 million through the combined buying power of the company's share repurchase program and the Blue Owl employee investment vehicle. As of May 10, an incremental $22 million of ORCC stock was purchased, bringing total stock purchase to $74 million at an average price of $12.22, of which $49 million was repurchased by the company. For the second quarter of 2023, our Board has declared a $0.33 per share regular dividend, which will be paid on or before July 14 to shareholders of record as of June 30. Our Board also declared a supplemental dividend of $0.06 per share for the first quarter of 2023, which will be paid on June 15 to shareholders of record on May 31. As a reminder, we instituted a supplemental dividend on the back of our continued earnings momentum to ensure that our shareholders benefit from the higher rate environment. We expect to continue to evaluate our dividend policy going forward to ensure we are striking the optimal balance of sharing upside while also protecting the stability of the dividend across all market environments. Additionally, we have a flexible balance sheet with a well-diversified financing structure. We ended the quarter with net leverage of 1.21x, largely unchanged from where we ended the prior quarter and within our target range. We also had liquidity of $1.7 billion, well in excess of our unfunded commitments of approximately $940 million. Lastly, this quarter, we saw some stress in the market as the banking sector crisis played out. In response, our financing team rigorously analyzed the impact of a number of potential outcomes on our liability structure. We found that we had no material exposure to the affected banks, and we saw no impact to our fund operations. We believe this highlights the quality of our balance sheet and the benefit of having diverse funding sources. We deliberately built our balance sheet to have a significant amount of unsecured bonds. Over 50% of our liabilities today and our revolver is made up of a large diversified group of 19 lenders, led by large global banks. This allows us to have material over-collateralization on our secured facilities, and we have structured those facilities to have limited mark-to-market exposure. We have over 60 unique finance partners across our secured facilities. In addition, our weighted average cost of debt remains low at 5.2%, and we have no near-term maturities. For these reasons, we remain pleased with the strength of our liability structure and believe it will serve as a competitive advantage, providing the portfolio with flexibility and durability across market environments. With that, I will turn it back to Craig for closing comments.

Craig Packer, CEO

Thanks, Jonathan. To close, I'd like to touch on the current market environment, which remains a very attractive one for direct lending. With the public market mostly unfavorable for new issuance, we continue to see direct lenders financing nearly all of the deals that are coming to market. These opportunities are attractive because they are for high-quality borrowers with enhanced spreads, documentation and leverage levels. As we've noted before, given continued low repayments, ORCC is currently benefiting from this environment, largely through amendments and other repricing events which continue to help increase the overall spread on our portfolio. Our growing incumbency positions are also helping to drive additional deal flow in a slower M&A environment. More broadly, recent volatility in the credit markets and general capital constraints have underscored the benefit of scale for direct lending platforms. Given the potential challenges to come over the near to medium term, we believe that the market environment over the next couple of years will favor larger platforms like ours. Size and scale are increasingly important when it comes to fundraising, deal flow and access to financing as well as hiring and retaining top talent. And we believe that the strength of our platform will be even more apparent during this time. When conditions are more challenging, people naturally gravitate to the stability and security that larger platforms provide, and we expect to be a beneficiary of this dynamic. Our competitive positioning today is as strong as it's ever been because of our scale and deep relationships with sponsors. And we believe that sponsors and borrowers value our capital, look to us as a preferred partner for financing solutions. Before we open it up for questions, I want to spend a few minutes on our upcoming Investor Day on May 24. This is our first Investor Day, and we're excited to have the opportunity to discuss ORCC as well as our other BDCs in more detail to highlight what differentiates our direct lending platform. We have a full day planned, including sessions with senior members of our investment team, discussing our approach to origination, underwriting and portfolio management to provide further insight into our disciplined approach and how we have built our exceptional track record. We will also cover why we believe ORCC is well positioned to deliver attractive returns through various market cycles and how the stock offers a compelling total return opportunity. For those of you that are new to our story, ORCC trades around 85% of net asset value. And some of our most comparable peers trade around 100% of net asset value. So as a result, ORCC offers not only the opportunity for an attractive dividend yield but also the potential for capital appreciation to net asset value if the stock is able to trade in line with those peers over time. We believe the current environment is one where our portfolio will not just fare well but will outperform. As we've noted before, we are prepared for conditions to get tougher from here but remain firm in our belief that any challenges will be manageable. This is because we have been extremely disciplined on credit selection and believe our portfolio will continue to perform very well and generate strong returns. We have also been proactive in fortifying ORCC's balance sheet with diversified financing sources. We seek to maximize flexibility and have locked in low-cost debt with no meaningful near-term maturities. I look forward to seeing many of you at the upcoming Investor Day and hope that you will come away from the event as confident as we are in our process, our people and our strong credit performance. On behalf of our entire team, we look forward to sharing more on why we are so excited about the future of ORCC. With that, as always, thank you for your time today. And we will now open the line for questions.

Casey Alexander, Analyst

I have two questions. One, I heard your comment about expecting the interest coverage ratio to decline to 1.5x in the second half of the year. I didn't hear what it is currently. And then the second part of my question is what are the inputs that went into that in terms of your assumptions? I mean, how much of that is expected company performance versus how much of that is expected rate development?

Craig Packer, CEO

Sure, Casey. So it's 2.2 reported through the first quarter. We think it's going to trough at 1.5 in the back half of this year. We did do some analysis around performance, and it does bake in the impact of a moderating economy. We expect the economy to weaken. And so we baked that into that number, but the most significant impact is higher rates. And so I don't have a precise number for you, but if I had to guess, it's 75% rate.

Casey Alexander, Analyst

Okay, my second question is about Walker Edison, which was restructured during the quarter, yet you decided to keep it on nonaccrual. I understand that, based on the investment schedule, it's currently 100% PIK. However, typically when something is restructured, it comes off of nonaccrual. I'm curious about your reasoning behind this decision.

Craig Packer, CEO

Yes, that's a good observation. We try to be very thoughtful about every decision and investment when we decide to place it on nonaccrual and assess its prospects. You’re right, we restructured this position. Typically, we restructure in a way that the remaining debt would be a par instrument and on accrual. Regarding Walker, this is a business that produces ready-to-assemble home furnishings, like coffee tables. It benefited significantly from COVID and the stay-at-home trend but has since experienced a downturn. Additionally, there have been some supply chain challenges. Although we restructured the debt and incurred a significant loss, the business continues to face difficulties. Given its current challenges, we believe it is prudent to keep it on nonaccrual. This recovery will take longer than some of our other troubled investments, which have typically responded quickly. This situation is going to take more time, and based on our assessment of the company's current status, it’s best to keep it on nonaccrual for now. We hope to see improvement in performance and will reevaluate it on a quarterly basis.

Robert Dodd, Analyst

Congrats on the quarter. I mean, Jonathan mentioned the bank disruption and the fact that the liability side is. On the asset side, I mean, something like Wingspire, where you've been putting in more capital, obviously, they do working capital lines, they do equipment financing, all areas where regional banks are typically big players and maybe less so going forward. So should we expect a better performance from Wingspire and maybe an acceleration in capital invested in that vehicle given its target market seems to be moving in a favorable direction?

Craig Packer, CEO

We have been very satisfied with Wingspire's performance. We developed that business organically with a highly experienced management team, and it took some time for them to gain the current momentum. It's doing well and generating attractive dividends and returns on equity for ORCC. We communicate with them regularly, and they appear to be in a favorable market environment. We plan to continue providing additional capital to Wingspire as they identify opportunities. If regional banks reduce their credit support, it could create more opportunities for Wingspire. While we haven't seen that impact yet, it’s reasonable to expect it will occur. Additionally, in a weaker economy, companies tend to rely more on asset-based financing. I share your view that there will be more opportunities for Wingspire, allowing us to invest more capital and achieve strong returns.

Ryan Lynch, Analyst

First question I just had. Have you seen any sort of pullback in funding in the CLO markets or any sort of slowdown in funding in the CLO markets with the sort of disruption that we've seen in the banking sector? Or has that market been functioning kind of the same kind of pre-banking crisis versus post-banking crisis?

Craig Packer, CEO

So I'm not sure if you're asking about how we are using CLOs to finance our portfolios? Or you're just talking about the general BSL CLO market?

Ryan Lynch, Analyst

Yes. I'm talking about the general BSL market. Obviously, there's been a big shift in loans to the direct lending marketplace. That's just probably going to continue. I'm just wondering if there's further disruption in the CLO funding and margin.

Craig Packer, CEO

I believe the market is operating well. While it may not be the strongest CLO market we've encountered, it is functioning properly. We have been active in this market, and although it is slightly more expensive, it remains open and is not experiencing any major disruptions. In fact, over the past few months, there has been a positive trend in BSL and overall strengthening conditions in that segment. I don't view it as a weakness or a concern; rather, I see it as functioning well with potential for growth from here. I wouldn't identify it as a specific stress point, if that is what you were inquiring about.

Ryan Lynch, Analyst

Okay. My other question is about the current marketplace challenges due to economic impacts affecting various industries differently. Some industries are experiencing tailwinds. As you review your portfolio, is there one industry that stands out as outperforming others in this economic environment? Additionally, is there any industry that seems to be underperforming or facing potential headwinds due to the current economic conditions?

Craig Packer, CEO

Overall, most of our sectors are performing well, with continuing revenue and EBITDA growth. While the growth is somewhat slower, it remains positive, and we see strong performance across all industry groups. We believe the software sector is the best performer and is achieving solid results from our software companies. We also have significant involvement in the insurance space, which is less sensitive to economic cycles and is performing well. Some individual companies that faced challenges during COVID are starting to recover, but there isn't a notable positive trend overall. In terms of sectors with some weaknesses, there are areas in the consumer market where businesses that benefited during COVID are now experiencing slower demand as people have reduced their orders. Additionally, some consumer businesses are facing cost pressures that have led to underperformance, with Walker being one example, although it has its own larger issues. In healthcare, a small segment is dealing with rising labor costs or difficulties in hiring, leading to increased overtime or lower capacity. Some providers are unable to pass on price increases quickly due to contractual obligations. It's important to note that this pertains only to a small part of our healthcare business, so it shouldn't be generalized across the board. These are just a few examples of areas in our portfolio showing some underperformance, but they are relatively limited compared to the overall performance.

Kevin Fultz, Analyst

With leverage at your stated target, I know that the level of investment activity was largely driven by matching deployments to repayment activity. But I'm curious how you would categorize the investment landscape right now and how attractive are the deals you're reviewing relative to other vintages. And also if recent turmoil in the banking sector has created even more compelling investment opportunities for Owl Rock.

Craig Packer, CEO

Sure. I mentioned this last quarter, and I believe it's likely the best environment we've experienced since going public for new investments. Spreads are still elevated, and base rates are quite high. Moreover, we're obtaining very appealing upfront OID and higher-than-usual call premiums. This translates to earning 12% to 13% on unitranche compared to 7% or 7.5% a year ago. While I don’t want to overstate this, achieving 12% to 13% on first lien unitranche debt at 45% loan-to-value is quite exceptional. The value is excellent, and the deals we are pursuing are of high quality as well. The businesses are substantial and leaders in their sectors, accompanied by solid documentation. Overall, the deals we are engaging in are highly attractive for our portfolio. For the funds we manage that have more capital, we are maximizing opportunities in those areas. It’s a favorable environment for direct lending, with the shift from public to private being one source of deal flow, while add-ons for our existing portfolio companies represent another. We have a strong preference for the opportunities we like. Regarding the banking sector, I maintain a balanced perspective. While I frequently get asked about this, we focus on upper middle market, private equity-backed deals, which typically don't put us in direct competition with regional banks. Our main competition comes from other direct lenders and larger banks that arrange but do not hold loans. When regional banks retreat, it doesn't really affect our core business. However, it stands to reason that non-sponsored companies might face more challenges securing financing. If there are any such companies listening, we would love to engage with you. That said, I don’t anticipate a significant increase in these opportunities because regional banks are usually not involved in non-investment-grade loans. My cautious stance comes from the potential impact that the pullback of regional banks could have on the overall economy and on our portfolio companies' access to financing from these banks. While some have suggested that the situation could be beneficial for direct lenders, I'll take a wait-and-see approach to gauge its effects on the economy, though selective opportunities may arise. Ultimately, I favor a functioning banking system and a robust economy, and I hope we reach that point soon.

Kevin Fultz, Analyst

Okay. That's really great insight. And then just one more. Can you provide an update on portfolio company leverage?

Craig Packer, CEO

Portfolio company leverage. So we talked about interest coverage. Our portfolio company leverage is probably in mid-60s-ish.

Mark Hughes, Analyst

Just a question on the trajectory of new fundings or new commitments versus what gets repaid or sold. As the market opens up a little bit, do those move in parallel or does one kind of move ahead of the other as the cycle progresses, so to speak?

Craig Packer, CEO

Sorry, Mark, I heard you, but I'm not sure I followed it. Does what move in parallel?

Mark Hughes, Analyst

Just the trend in new commitments compared to pay-downs. Does one occur before the other?

Craig Packer, CEO

We have a leverage target of 0.9 to 1.25, and we're currently positioned towards the higher end of that range, which we believe is optimal. Our aim is to stay within this target without exceeding it. Essentially, we are coordinating new investments with repayments. As we gain clarity on repayments, we will do our best to align new investments accordingly. While it's not always possible to be exact because deals don’t occur daily, we generally manage to align them quite effectively within a quarter. If there were a significant increase in repayments, there might be a slight delay. However, we are far from that scenario. In a more modestly increasing repayment environment, we would continue to introduce new deals. We are actively making new investments on our platform each week, and there are currently opportunities for additional investments in ORCC. We are carefully sizing these investments to maintain stable leverage, allowing us to remain flexible as repayment opportunities arise. All right. Terrific. Thank you all for listening. I really encourage everyone to tune into our Investor Day. We're quite excited about it. You're going to get, I think, a much deeper understanding of our team, our process, a lot of the topics we've touched on today. And so please tune into it. If you need any help on how to get access to it, just reach out to our team, and we will help you there. Thank you, and have a great afternoon.