Oaktree Specialty Lending Corp (OCSL) Q1 2021 Earnings Call Transcript

Good morning and welcome. Thank you for joining the Oaktree Specialty Lending Corporation's First Fiscal Quarter and 2021 Conference Call. Today's conference call is being recorded. At this time, all participants are in a listen-only mode, but we will be prompted for question-and-answer session following the prepared remarks. Now I would like to introduce Michael Mosticchio of Investor Relations, who will host today's conference call. Mr. Mosticchio, you may begin.

Thank you, operator, and welcome to Oaktree Specialty Lending Corporation's first 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 Chief Operating Officer; and Mel Carlisle, Chief Financial Officer and Treasurer. We will be happy to take your questions following their prepared remarks.

Thank you, Mike, and welcome, everyone, to our first quarter earnings conference call. We appreciate your interest in and support of OCSL, and we hope everyone listening is well. We are off to an excellent start to fiscal year 2021. OCSL delivered solid results for the quarter, with earnings, origination activity, and credit quality all strong. We reported NAV per share of $6.85, a 5% increase from the prior quarter. This increase reflected both gains from the realization of a non-core investment that was previously a non-accrual as well as ongoing price recovery in our liquid debt investment, which has continued since the market sell-off in March. In fact, as a result of our portfolio's strong credit quality and performance since then, our NAV as of December 31 is 3.6% higher than it was one year ago. Adjusted net investment income per share for the quarter was $0.14, compared with $0.17 for the prior quarter. The decrease was primarily due to lower investment income compared to the previous quarter, where we generated exceptionally strong interest income in the form of medical interest and OID acceleration from the repayment of our investment in NuStar Logistics. Excluding this amount, which contributed approximately four cents to adjusted NII last quarter, earnings would have been up as a result of the portfolio's continued growth and increasing yield. Based on our consistent performance and our expectations for continued strong earnings, our Board increased our quarterly dividend by 9% to $0.12 per share, the third consecutive quarter with a dividend increase. This amount represents a 26% increase from the dividend level one year ago. We had another strong quarter of originations where we originated $286 million of new investment commitments. Of these new commitments, nearly 70% were first lien loans, which included $181 million in private transactions, $84 million in the new issue primary market, and $22 million in secondary market purchases. We received $161 million from paydowns and exits in the quarter, including $23 million from our exit of a non-core position that was previously a non-accrual.

Thanks, Matt, and good morning everyone. The rebounding credit and equity markets that we saw in 2020 have continued into 2021, supported by still vulnerable, but improving economic conditions and consumer sentiment as well as exceptional fiscal and monetary stimulus. The rollout of COVID-19 vaccines and commitments by the new administration to accelerate that process provide reasons to believe we're nearing the final stages of this public health crisis, adding to investor confidence. That said, valuations feel elevated and might not necessarily reflect current macro conditions or the prevailing outlook for gradual economic growth this year. The ultimate pace of inoculations remains uncertain, and projections for GDP growth assume an end to the pandemic in the second half of calendar 2021. While hopeful, we're also cautious about assuming too much about the final outcome at this stage. With that sense of caution in mind, we continue to approach new investments defensively. We think it is important to view market exuberance with a critical eye and to avoid perilous investment opportunities. We remain focused on protecting the downside in our investments and seeking appropriate compensation for risks taken. Given Oaktree's scale and resources, we are able to invest across multiple markets with diversified businesses. This enables us to focus our portfolio on stable and lower-risk sectors, notably including those largely unaffected or even positively impacted by COVID. We continue to identify compelling opportunities in the life sciences and technology companies that are delivering healthcare solutions or capitalizing on the increased level of digital commerce. We're also seeing more direct lending opportunities and supportive leveraged buyouts of businesses that have proven resilient in the face of the pandemic, and ones that are not easily underwritten via traditional cash flow-based methodologies. Finally, as we did last year, we continue to carefully study the rescue lending landscape, an area in which we have found appealing opportunities, including two investments that we made in the first quarter that I will discuss in more detail shortly. As Matt noted, we are also exiting positions in which we believe there's limited further upside, including some of our lower yielding broadly syndicated loan positions.

Thank you, Armen. Good morning, everyone. OCSL generated strong financial results in the first quarter. Total investment income was $38.2 million, down from $43.6 million in the previous quarter. The $5.4 million decline was due to lower interest income, based on lower make-whole interest and OID acceleration from loan payoffs, as Matt noted earlier. Net expenses for the first quarter totaled $28.2 million, up $9.1 million sequentially. The increase was driven by higher accrued part two incentive fees. This was partially offset by lower part one incentive fees, mainly due to the decrease in investment income. For the quarter, OCSL reported net investment income of $10 million and adjusted net investment income of $19.6 million or $0.07 and $0.14 per share respectively. As a reminder, we define adjusted NII excluding capital gains incentive fees for part two incentive fees. During the first quarter, OCSL approved a total of $9.5 million in part two incentive fees. This amount was mostly due to $48 million in net unrealized gains in the portfolio during the first quarter. It is important to note that while GAAP requires us to take unrealized gains into account when accruing part two incentive fee expense each quarter, OCSL will only pay part two incentive fees annually, and to the extent that it has realized gains that exceed realized and unrealized losses at year-end. Turning to credit quality, which continues to be very strong. As Matt noted, at quarter-end, we had one investment in non-accrual representing three basis points of the total portfolio at fair value, down from 10 basis points in the prior quarter. The decrease was primarily due to the successful exit of Edmentum, where we realized a full recovery on our debt investment and reported a total gain of $23 million. During the quarter, all of our portfolio companies made their scheduled interest payments. And since March, only one company has converted its cash interest payments to pick.

And the first question will come from Devin Ryan of JMP Securities. Please go ahead.

Hey Great there. Good morning, everyone.

Good morning.

First question here just given the overlap between OCSL and the OCSI on the investment side and expectations that the merger will be relatively seamless. It would be great if you could give some additional granularity on expectations for the cadence of investment activity in the coming quarters as it pertains to repositioning the two portfolios. What I'm trying to get at here is you hear the comments about a very strong pipeline, and obviously expectation for investment versus some of the comments around valuation and market exuberance and just trying to think about the push-pull in all of that.

Sure, Devin, this is Armen. So in terms of overlap with OCSI, and then the cadence of investing after the merger is closed, in terms of non-overlapping investments that you know are in OCSI but not in OCSL. It's about 33% of the OCSI portfolio at this point, of which 25 percentage points are actually public securities that can be traded at about $47 million or so of par value of private positions, which will take a little bit longer to rotate. So it's a pretty manageable rotation after the close of the merger that we think we can effectuate. However, as you alluded, that will obviously be predicated on our ability to continue to originate attractive loans. Maybe we could talk a little bit about the markets; I'm sure others will be asking about what we're seeing in the market these days. I would say that in private credit, it’s not like you can take all of private credit with the same paintbrush. There's middle market sponsor finance in support of LBOs, or some mezzanines within that their second lien. More typically, what we like doing are the non-sponsor loans that are harder to predict the timing of; they're more structured, they're harder to find and take longer to execute. What I would say is that on the sponsor side, especially the more typical first lien or unitranche loans, that market is back to pre-COVID competitive levels whereby your private equity sponsors are coming to market; they're blasting out pitch decks to a variety of middle market direct lenders. Pricing has taken a little bit of a hit, not as much as one would think, but legal terms are taking a hit in terms of covenant light and other flexibility around covenants and terms in these credit agreements. For us, we're finding yet again that we are rejecting a whole lot more of that deal flow or just finding it less interesting than we are committing to it. We're turning over a lot of stones with very few investments. That said, we will continue to do some middle market sponsor finance, especially with those sponsors that are very close relationships of Oaktree; we think have an operational advantage in particular sectors. We have a few things in the pipeline now with sponsors that meet that description. We expect that we will still originate some deals there, but we are not going to be the typical flow first lien or unitranche lender out there that is willing to cave on legal terms. In fact, we would be more willing to cave on financial terms than on legal terms, just given the background of Oaktree as a downside-focused lender. On the other side of the house, the more opportunistic, non-sponsor side, as Matt and I mentioned, we've been active over the last several quarters in rescue lending or providing liquidity to sectors and companies that are experiencing some level of dislocation due to COVID. We don't expect that opportunity to fully go away, even with the positive reaction the market has shown over the last several quarters, but it certainly has declined. The pace of our deal flow has declined. We were engaged with a large issuer over the last couple of quarters on a rescue in partnership with our opportunities funds. With the exuberance in the markets, they essentially were able to place a bond several hundred basis points tighter than what we were willing to provide them in the public market. We recognize that the public markets are taking opportunities from us. However, many industries, many businesses are going to continue to need capital over the next several quarters, and we will engage in highly structured solutions for those companies. In that same theme of non-sponsor lending, our activity in the life sciences area continues to be robust. We were very active last year in life sciences and have a few deals that we're considering now in the pipeline that are very attractive, consistent with our prior structures and return expectations. We expect we'll continue to do that. I know that I kind of went around the world a little bit there on the market color, but we feel pretty good that we will be able to transition the OCSI portfolio over a few quarters; it’s not going to be over one quarter, but within the one to two years that we've contemplated, it will take just given the strength of our pipeline, especially in the non-sponsor area. It helps that so much of the non-overlapping positions are publicly traded securities that are frankly trading quite well under the current market circumstances.

Okay, that's terrific color, I think Armen. And then maybe just a follow up here, this one might be difficult, but you've had three consecutive quarters of increasing the dividend, which is great. I'm not sure if you can maybe just help us think about the outlook for the rest of 2021 and the trajectory and if you can't give kind of specifics, what should investors be looking for, in order to think about kind of the dividend continuing to trend higher from here?

Yes, thanks for raising the question. We're really not comfortable providing forward-looking guidance on things like dividends or earnings. We feel really good about the portfolio, the income it’s generating, and our pipeline. However, to make predictions on forward-looking items is something that we're just not comfortable doing right now, unfortunately.

And I think it's, it's Matt. The other thing, Devin, just that we're thoughtful about. As you pointed out, we raised the dividend the last three quarters. In the September quarter, we had a large kind of one-time item through the new stock payment, which flowed through investment income. This past quarter, we had another one-time item that also flowed through investment income. We want to be mindful of those one-time items. If you take those out and just look at our investment performance, going back to a year ago, it was $0.10 a year ago, $0.12 in the September quarter, and $0.14 in this quarter. So looking at our underlying kind of quarter-end recurring portfolio and income, that is one thing we're very focused on as the Board thinks about the dividend.

Okay, very helpful. I'll leave it there. Thank you guys. Appreciate it.

Thank you. The next question comes from Kyle Joseph of Jefferies. Please go ahead.

Hey, good morning. Thanks for taking my questions. Congratulations on another strong quarter. Start on your net interest margin, if you don't mind. Just give us a sense for on the yield side of things. Obviously, it sounds like spreads have tightened, but there's still some ongoing portfolio rotation opportunities. So give us a sense for how you've seen the portfolio yield trending. Obviously, it's been trending in the right direction. And then on the cost of funds side, are we at the bottom here? Are there any opportunities to reduce that and give us a sense for both of those and we can figure out in margins?

I'll go first. I think on the liability side, we've got, obviously, the unsecured notes, the cost on that. Then we have the revolver. We've received some really strong support from our banking group. We’ve decreased the size of the revolver over the last two quarters, and obviously have a lot of capacity there. The next dollar that we need to borrow, we would borrow from LIBOR, which is LIBOR plus 200. So I think that's pretty solid. On the asset side, last quarter, the yield was 8.7%, whereas the yield on the assets rolled off was obviously lower than that. I don't want to predict what the asset yield will be each quarter and what's going to roll off. But if you look at what we did last quarter, the other place we go to fund assets would be selling low-yielding assets, and you just pick up a spread on the assets. If something comes off at LIBOR plus 500 or 400 and goes on at LIBOR plus 700 or 600, there's that spread. It's just hard to predict, kind of each quarter, what's going to be refinanced. We've seen more in the end of last quarter and this quarter, more refinancing activities as the market has been robust. So it's just hard to predict that because a quarter ago, we weren't seeing that, and that will ebb and flow. But I think that gives you a sense of what we're trying to do on the asset side in terms of new origination and on the asset side in terms of selling lower yielding assets.

Yes, that's very...

If you look at our origination in the last couple of quarters, I mean, that's consistent with where we would like to continue to originate. So it's not like we are looking to go tighter than that. We're certainly not looking to take equity-like risks in anything we originated. That's really the origination you're seeing from us. That's kind of where our intention is going forward. We do have, just looking at our positions, a significant enough portfolio in OCSL that has yields with a coupon of LIBOR plus 450 or lower that can be rotated now. It will depend on the pace of our repayments as well on positions that we would ordinarily have liked to have kept, just giving the market strength. Those are being, to some extent, taken from us. We certainly have a targeted portfolio that we would like to exit and rotate into higher yielding instruments consistent with our last few quarters of origination.

Got it, very helpful. Thanks. And then I'd like to ask one on credit. Obviously, it's been very solid and way better than we would have initially expected last spring. But can you give us a sense for kind of amendment activity trends you're seeing? I know you mentioned that only one investment had moved to pick, and then just give us a sense for revenue and EBITDA growth or performance in the fourth quarter, and how that compared to the third quarter for the portfolio broadly?

Sure, this is Armen. Yes, on the amendment side, it's been very quiet. We continue to only have one name on non-accrual and one name that is subject to an amendment or a pick. We have not been contacted or not engaged with any other kind of material issues in the portfolio or around poor performance. We feel really good about our position. I don't expect for us to have a meaningful uptick in defaults based on the information at hand today. In terms of performance of the underlying companies, it's hard to generalize, but those industries that are most sensitive to COVID—such as entertainment-related businesses that are focused on live events, as well as leisure-oriented positions—are not very large positions in the portfolio. However, we do have some. These areas, along with some airline-oriented and aerospace and defense-oriented businesses are the most impacted from a top-line perspective. Businesses with exposure to live events have been experiencing very little to no revenue and are in a cost-cutting and cash flow preservation mode. In instances where we have exposure, the companies are sitting on a lot of cash and have very strong sponsor protection. In several cases, there have recently been buyouts by sponsors. When we reached out to those sponsors over the last 12 months, they indicated that they would let us know if they need incremental liquidity. They don't believe they will, and they think they can manage the cash. Thankfully, we don't have much exposure that’s deeply impacted by COVID. In areas where we do have exposure, the companies can either cut costs or have a strong sponsor willing to infuse capital if necessary.

Got it. Very helpful. Thanks a lot for answering my questions.

No problem. Thank you.

The next question comes from Finian O'Shea of Wells Fargo Securities. Please go ahead.

Hi, everyone. Good morning. Just a first question on OCSI. For those of us who are a little less familiar. You put the Glick JV onto non-accrual due to COVID volatility. That's obviously a big investment that weighs a bit on portfolio yields. Are you able to update us on how you think about that? On being non-accrual that is.

Sure. We worked on non-accrual this last quarter as well. It is related to COVID-related volatility or sensitivity. The assets that Glick JV have appreciated in value considerably over the last few quarters. We will consider bringing back that position off of non-accrual every quarter. We will always consider that. We didn't feel comfortable doing it this quarter, but we will re-evaluate next quarter. I don't want to provide forward-looking guidance, but we're pleased with the performance of the underlying assets, both in terms of lack of default experience and market price appreciation.

I'll also add that although we are not accruing interest on the JV, it is generating positive net investment income. We are using that to pay down the subordinated notes and grow NAB there, which is a benefit to shareholders.

Yes, very well, thank you.

On the note that we have on the Glick JV, it is actually marked higher today versus December 31, 2019, to give you a sense of how our perception or our feeling around that position.

Okay, thank you. And then on one of your legacy names in OCSL, Dominion Diagnostics has been pulling on the revolver. It looks like a little more this quarter. Are you able to give us any color on what's behind that?

Sure. Dominion is actually a beneficiary of the pandemic. They are pretty actively involved with COVID testing. The company is performing as a result better than we expected. Its core business is certainly still suffering, but it's doing better. I would need to get back to you on the details, but I know the business has needed to staff up and buy working capital in support of this COVID testing business.

Okay, thank you. And just a small final question. Obviously, a very good quarter for you guys on NOI and NAV just on Edmentum being exited. I assume there was some top-line income that you received that's been on non-accrual for a while. Was that? Is that correct for one? And was that material impacts to your top line? The Edmentum income that you may have realized this quarter.

I'll ask Mel or Matt to answer that question. I’m not sure.

Sure. In terms of Edmentum, the majority of the income generated there was below the line as realized gain. As I mentioned in my prepared remarks, it was about $23 million. That wasn't a lot in investment income.

Yes, it is immaterial. It's not like we can go back and recognize interest income. But during the time it was a non-accrual, we directly recognized a small amount in the current quarter, but the majority was realized gains.

Okay, thank you.

The next question comes from Melissa Wedel of JPMorgan. Please go ahead.

Good morning. I wanted to touch base quickly on some of the new deployments this quarter and comparing that to sort of the levels and yield from last quarter. I want to make sure I'm thinking about this right. But your slide deck was showing about $240 million deploys this quarter at an average yield of 8.7% versus $146 million last quarter at 10.6%. So can you provide some context around that? And if there's anything sort of missing from that number that we should be factoring in?

Yes, thanks for the question. The quarter ended September 30 obviously began on July 1 and during those summer months, the activity around rescue loans in particular was higher than what it was in the following quarter. Frankly, what we're seeing today in the market. Our yields were highly correlated with that rescue lending opportunity. As that opportunity has subsided, we are dealing with issuers that are far less desperate and have potentially other options as those opportunistic lenders and middle market direct lenders that were fairly frozen in the second calendar quarter started coming back towards the mid to late part of the calendar third quarter, the quarter ended September 30. It’s the rescue lending that's been driving those double-digit type yields. As that has declined, so has our average yield to originations.

We also know there was one position that we originated in August, which might have gotten funded in early September. That was a 14% loan to a single borrower, and it's a decent size; it's the new Ag transaction. It probably skewed that quarter a little bit because of that one transaction. We will always look for those types of deals. This is just evidence that part of our business can be quite lumpy. We might have a quarter where we do very little in the non-sponsor area, and we might have a quarter like the one ended September 30 where we have a new Ag or a new star or something like that, that really, one or two deals might massively skew the average.

Okay, understood, that's really helpful. I guess, as a follow-up on that, do you see as much visibility into sort of a repayment pipeline? Anything big you are expecting?

Yes, I can't put numbers on it. But if you follow the broadly syndicated loan market, that's a pretty good indication for what we expect to see in the middle market landscape, potentially on a lag basis. In the broadly syndicated loan market, the best 90% of that market, if you exclude the bottom 10% because of default risk or just trading low for idiosyncratic reasons, that best 90% is trading pretty close to par or even above par at this point. And it's resulted in the month of January in a significant repricing wave in the broadly syndicated loan market. We had seen a couple of second lien positions that we recently took on in 2020 get repaid through the upsizing of a broadly syndicated first lien. The upsizing of the first lien took out the entirety of the second lien to reduce their cost of debt. It's hard for me to predict the volume of that impact going forward, but the market color I would give you today is that especially in the month of January, it's become quite active. It’s not surprising, given the fact that many inflows, retail inflows into broadly syndicated loan funds, as well as CLO creation, have driven those prices higher. Just as a last data point for the broadly syndicated loan market, the index was up about 135 basis points in the month of January alone. That’s a very, very big month, driven by the technicals there. I expect that, given those technicals and the strong fundraising year in 2020 and the last few quarters, middle market direct lending funds have been very actively fundraising. I suspect there will be an increase in repayment activity in the more flow-oriented LBO-backed part of the market. That’s a part of the market that’s very heavily trafficked, and the call protection is not material; it’s typically only about a year with some elevated call premium. I would expect some repayment activity to pick up in the middle market over the next couple of quarters if these current market technicals persist.

Okay, great. Thanks so much.

We have no further questions, Mr. Mosticchio.

Great. Thanks, Andrea. And thank you all for joining us on today's earnings conference call. The replay of this call will be available for 30 days on OCSL’s website in the investor section, or by dialing 877-344-7529 for U.S. callers or 1-412-317-0088 for non-U.S. callers with the replay access code 10151069 beginning approximately one hour after this broadcast.

The conference has now concluded. Thank you for attending today's presentation, and you may now disconnect.