Oaktree Specialty Lending Corp Q1 FY2023 Earnings Call

Welcome, and thank you for joining Oaktree Specialty Lending Corporation's First Fiscal Quarter 2023 Conference Call. Today's conference call is being recorded. At this time, all participants are in a listen-only mode, but will be prompted for a question-and-answer session following the prepared remarks. Now, I would like to introduce Michael Mosticchio, Head of Investor Relations, who will host today's conference call. Mr. Mosticchio, please go ahead.

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 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 include 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'd also like to remind you that nothing on this call constitutes an offer to sell or a 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.

Thanks, Mike, and welcome, everyone. Thank you to all on the call for your interest in and support of OCSL. Prior to my remarks, I would like to note that all per share amounts that we reference on this call have been adjusted for the one-for-three reverse stock split that we implemented on January 23, 2023. Now turning to the results. We generated strong results in the fiscal first quarter as we identified compelling investments across sponsor and non-sponsor deals. This robust origination activity enabled us to further capitalize on higher base rates and spreads, driving profitability. First quarter adjusted net investment income (NII) was $0.61 per share, a 10% increase from the $0.55 earned in the prior quarter. The increase was driven primarily by higher total investment income that more than offset increased interest expense. Even as we grew, we remained highly selective, maintaining our defensively positioned portfolio and strong credit quality. We again had no investments on non-accrual. We are mindful that in a rising rate environment, overall consumer spending and business investment tend to slow, creating the potential for a recession. As a result, we are proactively managing risks that may arise in our portfolio should the volatility persist. Given the strength of our earnings, our Board increased our quarterly dividend by 2% to $0.55 per share, marking the 11th consecutive quarterly increase, and our dividend is up more than 90% from its pre-pandemic level at the close of fiscal 2019. Looking more closely at our first quarter results, we reported NAV per share of $19.63, down from $20.38 for the prior quarter. This decrease primarily reflected the $0.42 special distribution paid by OCSL during the quarter as well as unrealized depreciation related to price declines on certain public debt investments. In January, our portfolio experienced recovery in the prices of our core investments, and our NAV as of January 31 was estimated to be up approximately 1% to $19.83 per share. Turning to the portfolio, we originated $250 million of new investment commitments in the first quarter, more than double the level of the previous quarter. Of these, 85% were first lien loans. The weighted average yield on new debt investments was 13.1%, which compares favorably to the 9.9% yield on new originations in the September quarter, as we were able to identify and capitalize on investment opportunities with wider spreads in the December quarter. We received $104 million from paydowns, sales, and exits in the first quarter, as we continue to selectively reinvest proceeds into better risk-adjusted opportunities. Importantly, the pipeline is very robust in the current quarter. We are drawing upon the breadth of the Oaktree platform to source attractive deals with strong downside protections. Looking ahead, we expect substantial benefits from our merger with Oaktree Strategic Income II, Inc., or OSI2, which we closed in January. Our combined company has more than $3.3 billion of assets on a pro forma basis, resulting in an increase in first lien investment to 74%, creating greater scale and financial flexibility, while maintaining our value-driven investment strategy. We expect the merger to be accretive over the near and long term through cost savings, which we expect will total approximately $1.6 million of cost and operational synergies annually. We will also benefit from reduced management fees for the next two years as Oaktree, our manager, has agreed to waive $9 million of base management fees in total, $6 million in the first year, and $3 million in the second. Since the closing of the merger, our trading liquidity has improved, and we have been making enhancements to our capital structure. Together, we are in excellent financial shape with strong liquidity and capital levels, and we are well positioned to continue delivering attractive returns to our shareholders. With that, I would like to turn the call over to Armen to provide more color on our portfolio activity and the market environment.

Thanks, Matt, and hello, everyone. I'll begin with comments on the market environment. The US job market finished calendar 2022 in relatively strong shape with steady job growth. The economy also grew at an annual rate of 2.9% in the calendar fourth quarter. However, both measures marked a slowdown from earlier months, likely reflecting the Federal Reserve's aggressive rate actions. While futures markets anticipate additional rate increases at the next two Fed meetings, they are also betting that they will pause by late spring and before the end of the calendar year will begin to once again lower rates. The case for this dovish pivot appears driven by the expectation that US inflation will continue to decline at a fairly rapid rate. However, while inflation in the US has slowed, China, the world's second-largest economy, has fully reopened, which will likely boost global economic growth and may simultaneously exert upward pressure on global inflation this year, impacting prices in the US. Further, the US labor market continues to be historically tight with strong job growth and the lowest unemployment rate in more than 50 years. Still, recent figures show a mixed picture of US economic health, wage growth is leveling off, and consumer spending is starting to ease, signaling that the US economy is slowing and could slide into recession. All of that noted, the uncertain economic backdrop creates new opportunities for Oaktree. We have experienced across all market cycles and with a strong capital base and a long-term perspective, we have the conviction needed to withstand short-term volatility and continue to invest and generate strong returns for our shareholders. While we will remain cautious moving forward, we are also confident in our team's long history of identifying new investment opportunities while maintaining solid credit quality. As you have heard me emphasize on previous calls, we focused on relative value in areas of the market where we can find the best risk-adjusted returns. We draw upon Oaktree's scale and resources to invest across multiple areas, including the sponsor and non-sponsor backed markets, leveraging the firm's ability to negotiate and structure customized deals that provide downside risk protection. Altogether, we are deploying capital on favorable terms to further build our portfolio and generate strong returns for our shareholders. Now turning to the overall portfolio. At the close of the first quarter, our portfolio was well diversified with $2.6 billion at fair value across 156 companies, up from 140 a year earlier. 86% of the portfolio was invested in senior secured loans, with first lien loans representing 72%, underscoring our emphasis on being at the top of the capital structure. We continue to emphasize larger, more diversified businesses that present lower risk because they're better equipped to navigate downturns. Overall, our borrowers have been navigating the current inflationary environment very well and have continued to experience steady performance despite the challenging market conditions. Median portfolio company EBITDA as of December 31 was approximately $128 million, generally in line with the prior quarter. Leverage in our portfolio of companies was relatively steady at 5.1 times, well below overall middle market leverage levels. The portfolio's weighted average interest coverage declined slightly to 2.5 times as of December 31 from 2.7 times in the prior quarter due to rising base rates. We leverage the Oaktree platform to originate $250 million of new investment commitments, of which $235 million was committed to new portfolio companies in the quarter. Let me share a few representative examples of our new investment activity. First, we originated a non-sponsored loan to Superior Industries, a public company that is a leading designer and manufacturer of aluminum wheels. It sells to original automobile and light truck equipment manufacturers, as well as aftermarket distributors in North America and Europe. The company holds a strong market share, maintains a low leverage profile, and generates high free cash flow, supporting healthy margins. The deal consisted of a $400 million sole Oaktree commitment in a senior secured term loan that was used to refinance existing debt. OCSL was allocated $40 million, and the loan was attractively priced at SOFR plus 800. LATAM Airlines Group is another good example from our first quarter. It is a leading provider of passenger and cargo air transportation services throughout Latin America and it also applies to major destinations in North America and Europe. As you may recall, OCSL previously had an investment in LATAM as part of its restructuring in late 2020. The company came back to the market to refinance existing debt and raise additional working capital. A deal involved an Oaktree led $1.1 billion syndicated loan, of which Oaktree funded $750 million, priced at SOFR plus 9.5% with call protection and an 8.5% original issue discount. OCSL was allocated $26 million of the total loan. Notably, we are also continuing to find opportunities in discounted CLO debt and ABS. Our CLO and ABS purchases totaled $20.7 million in the quarter with an average price of 87% of par. We see significant potential for upside should these return to par over time. In summary, our strong liquidity position, experienced across both periods of growth and contraction, as well as the sourcing power of the Oaktree platform continue to put OCSL in excellent position for 2023. Now, I will turn the call over to Chris to discuss our financial results in more detail.

Thank you, Armen. OCSL had another strong financial performance to start fiscal year 2023 with good momentum. In the first quarter, we achieved an adjusted net investment income of $37.1 million or $0.61 per share, which is a 10% increase from $33.7 million or $0.55 per share in the fourth quarter of fiscal year 2022. This growth was mainly driven by higher interest income due to rising base rates, although it was partially offset by increased interest expenses. Our net expenses for the quarter were $40.3 million, up $6 million from the previous quarter. This rise was primarily due to an additional $5 million in interest expenses resulting from the impact of higher interest rates on our floating-rate liabilities, along with modest increases in base management fees and Part I incentive fees due to our larger portfolio and its strong performance during the quarter. Professional fees also saw a slight increase due to seasonality. Our credit quality remains excellent; as Matt mentioned, we had no investments on non-accrual by the end of the quarter. Regarding interest rate sensitivity, OCSL is well positioned to benefit from a rising rate environment. As of December 31, 87% of our debt portfolio at fair value was in floating-rate investments. Our strong earnings in the first quarter were again due to higher base rates, which increased our interest income. We anticipate that the recent rate hikes will continue to positively affect our earnings. If the base rates as of December 31 had been in place for the entire quarter, we estimate our adjusted net investment income per share would have been about $0.03 higher, translating to adjusted NII of $0.64 per share. Moving on to our balance sheet, OCSL's net leverage ratio at quarter end increased from the prior quarter to 1.24 times, reflecting our strong and opportunistic originations, lower repayment activity, and a slight decline in NAV. Our leverage is now at the higher end of our targeted range of 0.9 times to 1.25 times debt to equity. However, leverage is expected to decrease slightly on a pro forma basis with the OSI 2 merger to around 1.16 times. As of December 31, our total outstanding debt was $1.5 billion, with a weighted average interest rate of 5.6%, up from 4.4% at the end of September due to higher base rates. Unsecured debt made up 43% of the total debt at the end of the quarter, which is a modest decrease from the prior quarter. At quarter end, we had sufficient liquidity to meet our funding requirements with approximately $357 million available, which includes $17 million in cash and $340 million in undrawn capacity on our attractively priced credit facilities. Our unfunded commitments, excluding those to joint ventures, stood at $172 million, with around $130 million of this amount available for immediate drawing since the rest is contingent upon certain milestones being met by portfolio companies. Regarding our two joint ventures, at quarter end, the Kemper JV held $409 million in assets invested in senior secured loans to 59 companies, an increase from $385 million last quarter, mainly due to $25 million in additional contributions from us and our JV partner, along with new originations, although this was partially offset by declines in the portfolio due to widening market credit spreads. The JV produced $2.6 million in cash interest income for OCSL during the quarter, up from $2.2 million in the previous quarter, reflecting the portfolio's continued strong performance and the effect of increasing interest rates on floating-rate investments. We also received a $1.1 million dividend, an increase from $875,000 in the prior quarter. The JV's leverage was 1.4 times at quarter end, unchanged from the previous quarter. The Glick JV had $137 million in assets as of December 31, down from $147 million at the end of September, consisting of senior secured loans to 40 companies. Leverage at the JV remained at 1.3 times at quarter end, and we received $1.9 million in principal and interest repayment on OCSL's subordinated note in the Glick JV during the quarter. In summary, we are very satisfied with our financial results for the quarter. We believe that our solid portfolio and robust balance sheet position us well for the rest of the fiscal year. Now I will turn the call back to Matt.

Thank you, Chris. Our strong financial results for the quarter enabled us to generate an annualized return on adjusted net investment income of 11.9%, up from 10.7% in the prior quarter. While we are very pleased with the growth in our earnings over the past several years, including our solid first quarter results, we believe OCSL remains well positioned to maintain and even build upon our strong return on equity (ROE) going forward. First, we believe OCSL continues to be positioned well for this rising rate environment, with 87% of our investment portfolio in floating rate assets. We expect to further benefit from the remaining interest rate increases that are expected to occur in the next few months. As we have discussed on prior calls, we continued to benefit from higher ROEs being generated at our joint ventures. During the first quarter, both joint ventures delivered ROEs of over 14%, as they are also benefiting from the rising rate environment and our ongoing portfolio rotation efforts. As I noted earlier, we expect that the cost savings and management fee reductions resulting from the OSI II merger will also support our returns. In conclusion, we are very pleased with our strong start to the fiscal year. Our portfolio is healthy, and we are well positioned to continue to capitalize on this increasingly attractive investment environment with our ample dry powder. Thank you for joining us on today's call and for your continued interest in OCSL. With that, we're happy to take your questions. Operator, please open the lines?

We will now begin the question-and-answer session. Thank you. Our first question is coming from Melissa Wedel from JPMorgan. Melissa, please go ahead.

Good morning. Thanks for taking my questions today. First, I just wanted to say thanks for the information that you provided sort of pro forma for the combined portfolio. I think it was slide 18 in the deck. Unless I missed it, I was wondering if you could help us think about what that combined pro forma portfolio yield looks like. With OSI 2 a little bit lower yielding than OCSL?

Hi. It's Matt Stewart. The pro forma yield is going to be pretty much unchanged post-merger. The overlap from OSI 2 into OCSL was around 97%. So, significant overlap, and so there's no material move in the portfolio yield.

I believe, Melissa, it's Matt. Considering the merger, the portfolios are largely similar. We benefit from rising rates as Chris mentioned. We also have operational synergies of $1.4 million, along with an additional $200,000 to $300,000 in interest expense and the fee waiver. When you combine these factors, you can get an overview of the March quarter.

Got it. That's very helpful. Thanks. And I assume the floating rate exposure would be similar as well given the high degree of portfolio overlap.

Yes.

Got it. Okay. That's my two questions. I'll hop back in the queue. Thanks.

Our next question is coming from Bryce Rowe from B. Riley. Bryce, please go ahead.

Thanks. Good morning. Wanted to maybe start on just the origination activity for the quarter, a nice strong quarter from a commitment and funding perspective. Wanted to get a sense for you all if this quarter's activity was more kind of seasonal strength, or would you say the opportunity set was just more attractive here in the December quarter?

Thanks for the question, Bryce. It's Armen. I think that, in the first half of 2022, pricing on the sponsor side of the market was generally not that attractive. We were very cautious about what we were doing on the sponsor side for most of the year. But beginning in August and September, it seemed like there was an air pocket in the market, especially on the sponsor side, pricing widened and legal terms improved. We're able to originate some very attractive sponsor and non-sponsored transactions. I think it's hard for me to say that it was a seasonal thing. But our activity was faster than it had been because of the quality of the deal flow, the pricing of it, the lower loan-to-values, and the better legal terms. So I wouldn't characterize it necessarily as seasonal, but it certainly was opportunistic, and I would say that in January, it's been a little bit slower, but we have been building up a decent pipeline for the rest of the first quarter and into the second quarter. So I think there was a little bit of a rush to get deals done in November and December that is now resulting in sort of pulling forward of deals that would have otherwise occurred in January. I don't know if you would call that seasonal, but these are kind of situations that have different timelines. So I think that just in light of the fact that we saw some good deals, we really pushed heavy in the fourth calendar quarter to get those deals done.

That's helpful, Armen. And then just around pricing of the new commitments, you highlighted a 13% plus weighted average yield, are you still seeing that level? And I think you mentioned at least you called out two specific investments. It sounded like both of those carry pricing that was around that level that you highlighted as far as the weighted average yield for the new commitments for the quarter. So I'm just trying to get a feel for whether that's an anomaly, or you're still seeing that level of pricing on actionable opportunities in the current environment?

Yeah. I would say the frequency of our deal flow, if you were to line up the pipeline that we have, there is a little bit of a difference between sponsor-led deal pricing versus non-sponsor. The non-sponsored is certainly in that 13%, 14%, sometimes higher range. The sponsor deals that we're doing these days are pretty much always first lien. The pricing is pretty much in the SOFR plus $650 million to $700 million range, and with SOFR at 4% and with OIDs on origination of two or three points, they're solving to about 11.5% to 12% for sponsor-led deals. So it is, I would say that most of the deals we're seeing are a little bit shy of 13%, but not a lot. I wouldn't say several hundred basis points lower, it's maybe 100 or 150 basis points lower. I do think that as long as base rates stay where they're at and as long as the market technicals stay in this type of dynamic where there's a more balanced interaction between lenders and private equity sponsors, that this type of pricing in the, call it, 11% to 14% range is possible.

Okay, okay. All right. Maybe last one for me. In terms of the joint venture, you saw a bit of an uptick in the dividend coming into OCSL from at least one of the joint ventures. Just curious if that's more a function of the higher ROEs that the joint ventures are generating, or is it a function of the, I guess, the increased investment you made in the JV here in the December quarter? Thanks.

Hi, it's Matt Stewart. It's a little bit of both. During the quarter, we drew down about $25 million of additional capital into the JV that we deployed into the market. But we did get the benefit of base rates that we saw in the portfolio in OCSL as well. But it's a little bit of both, and we were able to deploy a decent amount of capital during the December quarter.

Okay, great. Thank you guys.

And our next question is coming from Kevin Fultz from JMP Securities. Kevin, please go ahead.

I want to follow up on Bryce's question on the investment landscape. Clearly, it was a very active quarter of investment activity. And I'm just curious how you would compare the attractiveness of the current vintage of deals that you're doing relative to historical periods? And then if you can maybe parse out sponsor versus non-sponsor opportunities?

Sure, thanks, Kevin. Let's discuss non-sponsored deals first. These transactions are always unique, making it difficult to determine a standard market price since each one varies significantly. The competitive landscape differs notably between non-sponsored and sponsored deals. While non-sponsored pricing seems to have expanded, it doesn't appear to have widened by several hundred basis points. It's more like 100 to 200 basis points wider compared to one or two years ago. Additionally, legal terms and protections for non-sponsored transactions have historically been strict, and I believe they are even tighter now than they were previously. Loan-to-values are also somewhat lower now than they were a year or two ago. However, it’s important to note that loan-to-values in non-sponsored transactions are consistently lower than in sponsored deals; the deals we engage in always feature lower loan-to-values. This indicates that loan-to-values are now incrementally tighter compared to historical non-sponsored deals. Finding non-sponsored deals remains challenging, as it has always been the case. On the sponsored side, a typical first lien transaction for a new deal has seen changes in two key areas. First, regarding pricing, a typical first lien sponsor deal with 4.5 to 5 turns of leverage was generally executed at approximately 55% to 60% loan-to-value and priced at SOFR plus 500 to 550 from 2019 through the first half of 2022. Recently, particularly since August or September 2022, loan-to-value for such deals has decreased, marking the first significant change we’ve observed. Loan-to-values now sit around 40% to 50%, and pricing has expanded, averaging SOFR plus 650 to 675; higher leverage may even push this to SOFR plus 700. Notably, for tech or software LBOs, pricing is generally at least 50 basis points wider, landing in the SOFR plus 725 to 800 range. Consequently, in the sponsored deals, pricing has widened by roughly 125 to 150 basis points and loan-to-values are down by 10 to 20 percentage points. The third area we’d like to see change is regarding covenants. Middle market sponsor deals traditionally include maintenance covenants. While these have persisted, in the large-cap sector, we saw a re-emergence of covenants in the fourth calendar quarter for large-cap sponsor deals. For companies with $100 million of EBITDA or more, this shift was evident as banks have retrenched from the broadly syndicated loan market, leaving sponsors to adapt quickly. For example, we recently engaged with a significant private equity sponsor on a deal featuring a substantial equity contribution covering around 65% of the total capital structure, with a 35% loan-to-value. This sponsor managed to syndicate the transaction to a group of 10 to 20 direct lenders for about $800 million, effectively removing the maintenance covenant and creating a covenant-light deal. We opted out of this transaction after noticing the covenant was being eliminated, as we believed the company had cyclicality, and we prefer not to engage in covenant-light agreements. The aspect of maintenance covenants is crucial for us. While the fourth calendar quarter appeared promising, this situation could shift rapidly based on competitive conditions within the sponsor space.

Helpful color there. And I'll leave it there. Congratulations on a really nice quarter and for completing the merger.

Thanks, Kevin.

The next questioner is Kyle Joseph from Jefferies. Kyle, go ahead.

Hey, good morning, guys. Thanks for taking my questions. Curious to get your take on expectations for credit this year. Obviously, it seems like rate increases haven't yet impacted company credit performance broadly, including your portfolio. But is that kind of a timing thing? Like, how long can companies continue to perform under this higher rate environment? And how do you expect credit performance for the industry this year? And do you see any opportunities resulting from that?

Thanks, Kyle. This is Armen again. When discussing credit quality, it's important to consider two key factors: the unlevered performance of companies and the high cost of borrowing. Generally, companies not benefiting from inflation—like those in the energy or commodity sector—have seen an increase in prices, leading to higher revenues year-over-year in 2022. However, the rise in costs has outpaced revenue growth for many businesses. Consequently, while their revenues may be increasing, gross profit or EBITDA figures have not changed significantly and may have even declined in some cases. As a result, EBITDA margins and gross margins are mostly flat or declining despite increased revenues. This situation is concerning because, as companies raise prices for consumers, we are nearing a point in some sectors where demand is diminishing, leading to slower sales growth. There doesn't appear to be a bright outlook for the unlevered performance of these companies. No business seems to be thriving significantly, even amid inflation. Regarding leveraged free cash flow, which reflects cash flow after accounting for the elevated borrowing costs, this poses a significant issue, especially as base rates have been steadily increasing over the past nine to twelve months. As base rates rise, there is a delayed effect on borrowing costs as SOFR and LIBOR contracts reset, leading to continued increases into the fourth calendar quarter. Our dividend or return on equity would have been greater if base rates at the end of the quarter had stayed the same as at the beginning. This reflects a lag in company performance due to rising borrowing costs, which is challenging for borrowers. While this situation is beneficial for investment managers like us in terms of portfolio yield, it marks a significant and detrimental change in affected businesses. Over the past few years, direct lending has generally been priced at LIBOR plus 500 to 550 basis points. With a 300 basis point increase in SOFR above the LIBOR floor, the cost of borrowing has risen by 50% for unhedged borrowers. This is substantial, particularly given the unlevered corporate performance challenges. I expect an increase in risk across the portfolio and a rise in defaults, particularly in broadly syndicated loans. In the direct lending space, however, it remains uncertain whether this risk will lead to defaults due to the nature of bilateral relationships between lenders and borrowers. While defaults may be somewhat subdued, there will still be stress within portfolios that direct lenders will need to manage, particularly those supporting highly leveraged leveraged buyouts that have been priced at LIBOR plus 500, as these borrowers face significant pressure in terms of debt-to-EBITDA ratios and interest coverage ratios. Therefore, it’s essential to monitor this situation, as I believe default rates on broadly syndicated loans will increase and may serve as an indicator of stress in direct lending portfolios.

Got it. And then one quick follow-up for me. Just in terms of your prepayment or repayment pipeline, it doesn't sound like the merger should have really any material impact on that given the overlap, but kind of the outlook for repayments broadly in 2023, given all the moving parts macro-wise?

It's difficult to predict, but I would say that the borrowers in our non-sponsored deals typically took on leverage to achieve strategic goals rather than to artificially boost equity results. Once those goals are met, we receive repayments. In 2022, we saw several transactions that fit this description get repaid, and we expect more repayments in the coming months in the non-sponsored area, where we lend to growing businesses that need capital for their growth. The cost of debt in non-sponsored lending tends to be higher than in sponsored lending, making us appear expensive for these businesses as they strive to meet their objectives. Therefore, we anticipate receiving payoffs and refinancings in some of those non-sponsored transactions this year. On the sponsored side, it's harder to see similar outcomes. The volume of sponsor LBO transactions seems to be decreasing due to high borrowing costs for new deals, which suggests that many sponsored businesses in our portfolio or in the market are unlikely to transact among sponsors or go public. This indicates that the loans on the sponsor side are not expected to see significant repayments in 2023. That said, we do have a publicly traded book, and January has been strong for us. We view this book as a source of cash over time, so you might see repayments stemming from trading activity. We plan to reinvest that cash into private debt, ideally seeking higher yields and more structured options than what's commonly found in the market.

And just picking up on that, we've covered this a bit earlier. It's Matt, Kyle. The OSI II portfolio has the same liquid makeup as OCSL. So it's just more of that asset we can rotate out of.

Yes. Got it. Thanks a lot for answering my questions.

Thank you, Kyle.

We will now take a question from Erik Zwick from the Hovde Group. Erik, please go ahead.

Good morning. Thank you. Just wanted to first start with a question on portfolio leverage. You indicated that you're at the top of the range now and with pro forma for OSI II closing down to about 1.16. But given the fact that over the past 12 months, you were able to go from kind of the bottom of your range to the top of your range and it seems like investment opportunities are still plentiful today. How do you think about managing that leverage and continuing to grow out the portfolio here in the near term?

Thank you, Eric. We've seen some of the best opportunities in direct lending recently, better than in the last few years. This prompted us to increase our leverage to take advantage of those prospects. We also purchased publicly traded debt during a turbulent market in 2022, and this public portfolio now serves as a source of cash for new private deals without raising our leverage. We do not plan to increase leverage from current levels. We're constantly exploring market activities that could allow for portfolio growth, but we prefer to avoid growing through leverage at this time. Instead, we'll focus on managing our existing portfolio and taking actions in the capital markets when suitable. That's all I can share regarding that.

Yes. I think one of the things that as you look at the December quarter, that balance sheet was pre-merger, but we were working on the merger, announced the merger. We had the vote for January. So we are anticipating and expecting kind of managing the portfolio, assuming the merger would be completed. So that's why like the 1.16 number is really more operative than the 1.24 times.

That's helpful. And just a bit of a follow-up on the secondary market. Opportunities you mentioned, certainly a little bit slower in the last two quarters, but the pricing that you saw in the most recent quarter, according to Slide 6 was the most attractive you've seen. So just curious if that was a one-off opportunity, or would you expect to continue to see similar opportunities maybe in the next quarter or two at attractive pricing like that?

I think the pricing remains relatively stable for the opportunities we are currently assessing. For sponsor-led private credit, we are looking at SOFR plus 650 to 675 for typical non-software deals, while software deals are around SOFR plus 750. This pricing is consistent with what we observed in the previous quarters. On the non-sponsored side, it is generally higher. The challenge we face is predicting the pace of deal flow, particularly on the non-sponsor side. We can experience periods where we close many deals in a single quarter, but because our deals are opportunistic and tailored, it's difficult to forecast the pace of originations in that area. However, I would say that pricing has remained stable, at least so far this year compared to the latter half of last year.

Got it. And one last one, if I can squeeze it in. Just looking at the press release that there were 42 equity investments currently today, 30 of which you also hold a debt investment. So for those 12 where you don't currently have a debt investment, are these opportunities where the debt has repaid and you still have equity investments, or are there times or you only make an equity investment in companies?

Yeah. We generally don't take equity investments solely. It would be in a small handful of instances; the legacy portfolio that we acquired from Fifth Street that had restructured, and we own equity in those small handful, or it's an equity position that is left over from a debt position that did repay. But we don't buy just straight equity without a debt component attached to it as a matter of policy.

That's what I figured. Thanks for confirming. That's all for me today. Thank you.

A question comes now from Ryan Lynch from KBW. Ryan, please go ahead.

Hey, good morning. First question I had was just when I look at your liability structure post-merger with OSI 2. It looks like your guys' total unsecured borrowings drops to about 36% from 43%. Are you guys comfortable operating at that range where you'd be post-merger, or would we expect you guys to look at the capital markets to increase that number to a level closer where you guys have kind of operated historically?

Yeah. Ryan, it's Matt. Good question. So specifically answers, are we comfortable at this level? I'd say the answer is we are comfortable. The liability structure in OSI 2 with the liability structure we created, we knew the assets. That was one of the advantages of the transaction. So that just kind of moves over and we're able to actually re-price some of it more attractively. That being said, we're always looking at the unsecured market. We've had very good success with two unsecured deals. I think we're priced well, traded well. I think we have a very happy base of fixed income investors. So we'll continue to look at that as that market performs or kind of reopened. So we look at both, but we're comfortable where we are, but we obviously like to have a very balanced liability structure and capital structure in general.

Yes. Ryan, it's a good question. Just to build on it a little further, we would expect that natural opportunities arising from capital markets opening would allow us to adjust our structure. So, longer-term optimization would be the goal.

Okay, understood. Armen, you provided a rather bleak outlook on credit quality, particularly in the private credit markets. It seems the unlevered business performance is not great due to tightening EBITDA margins and pressures on levered cash flow from higher rates. With inflation showing some signs of easing, though it's still quite high, do you anticipate any reversal of these trends regarding margin pressures in 2023, or is inflation still too significant? Additionally, regarding EBITDA and levered cash flow, you mentioned an estimated interest coverage ratio of 2.5 times, which has slightly declined from the previous quarter. This offers some value, but the real risk is from borrowers affected by higher rates, especially those close to lower leverage thresholds. Have you conducted any analysis on your current portfolio to determine what percentage falls below a one times interest coverage given current rates or the forward LIBOR curve?

We are continually evaluating our portfolio to assess the risk profile based on fundamental factors or levered free cash flow. I'm not sure of the exact percentage of our portfolio that would fall below one times fixed charges, but it is likely minimal or nonexistent. You're correct that we should consider tail risk as part of our market analysis compared to the average. Overall, our portfolio is lightly leveraged. We monitor fixed charge ratios and leverage profiles across sponsored, non-sponsored, and publicly traded entities. We have successfully managed our leverage and fixed charge coverage, resulting in no significant names on our watch list, as evidenced by our lack of items on accrual. While I can't provide a specific percentage of the portfolio that would drop below one times coverage if base rates remain stable for a year, I can't report any such figures at this moment. Regarding your earlier question about whether inflation moderating could reverse some trends, it's an important point. Generally, companies have raised prices, but not as quickly as the increase in the cost of goods sold. For a reversal to take place, we would need a drop in prices alongside stable revenue, which could occur if price increases are delayed while costs stabilize. However, significant reductions in the cost of goods sold usually do not happen following inflationary periods; inflation may slow but rarely turns negative. Some sectors, like construction materials, might see temporary declines if demand drops, but I wouldn't expect widespread price reductions in the cost of goods sold that would lead to substantial profit opportunities. It's difficult to forecast inflation and interest rates for 2023. I believe the pace of inflation is slowing, which is encouraging and suggests a potential pivot. However, the market seems overly optimistic about a pivot occurring in 2023. The likely scenario is that the Federal Reserve keeps rates higher for longer than anticipated to ensure inflation is managed. Therefore, I wouldn't rely on a significant profit opportunity in 2023, although it could arise. Stability could be more likely toward the end of 2023 or into 2024, with a more balanced supply-demand situation and stable borrowing costs for most companies. We're expecting progress, but I don't think it will materialize this year.

Okay. That's helpful. That's all for me today. Appreciate the time.

Thank you.

And this concludes our question-and-answer session. I would like to turn the conference back over to Mr. Mosticchio. Please go ahead.

Thank you, Marliese, and thank you all for joining us on today's earnings conference call. A replay of this call will be available for 30 days on OCSL's website in the Investors section or by dialing 877-344-7529 for US callers or 1-412-317-0088 for non-US callers with the replay access code 6846351 beginning approximately one hour after this broadcast.

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