OXLC - Oxford Lane Capital Is Not The Bargain It Appears To Be

2023-10-12 06:14:48 ET

Summary

• Oxford Lane Capital Corp is attracting investors based on its high reported yield.
• The investment securities underpinning OXLC's performance, collateralised loan obligations, are complex and risky.
• Management fees are high and misaligned with shareholder interests.
• Investors should seek greater returns for less work elsewhere.

Oxford Lane Capital Corp. (OXLC) has gained attention from investors due to its high yield and novel underlying asset exposure. The company paid investors distributions totaling $0.90 per share in the financial year ended 31 March 2023, on a current share price of around $5.00 the reported yield is a jaw-dropping 18%. This yield is supported by an underlying portfolio of high-yield investments in Collateralised Loan Obligations (CLOs for short) - a complex security not widely available to retail investors. OXLC is one of the few places in the market where investors can gain exposure to such instruments and the yield associated. But novelty alone should not merit inclusion in a portfolio and investors should delve deeper to understand the reported 18% yield, where it comes from, and the associated risks.

High Yield, High Risk

A fundamental concept of investing is that risk and reward are intrinsically linked: each incremental dollar to be earned, should in theory require investors to take an incremental and proportionate amount of risk. OXLC investors may be focussing too much on the potential reward, and not giving enough weight or analysis to the potential risks.

OXLC is able to pay investors 18% yield because it maintains an underlying investment portfolio in specialist securities, CLOs, that are inherently risky - and complex. In brief, a CLO is effectively a portfolio, taking the legal structure of a corporate entity, of debt securities issued by companies. Typically, these companies are privately held, and below investment-grade, and the debt securities purchased by the CLO are illiquid.

The CLO structure itself is then split into a hierarchy known as tranches. Each tranche of the CLO has a specified claim on the earnings of the portfolio, and an obligation when it comes to losses. Comparable to the capital structure of a publicly traded company: senior debt securities are due to be paid first from earnings and bankruptcy, and equity investors get paid last.

The equity tranche of the CLO structure is what OXLC's investment strategy relies on to generate high returns. In the financial year 2023, OXLC reported total investment income of $262 million on a portfolio of $1.3 billion - a massive 20% yield. Unfortunately, in the same period, OXLC reported a loss of $324 million relating to the fair value of its investment portfolio caused by rising interest rates. A loss of this magnitude is a great demonstration of just how risky CLO investments of this nature can be.

Leverage

Unfortunately for investors, this loss was made worse by the fact that OXLC utilizes leverage. OXLC's annual report for the year ended 2023 shows $475 million of long-term debt outstanding relative to $1.3 billion of total assets. Therefore OXLC's capital structure is roughly 35% debt and 65% equity, meaning any gains experienced are multiplied by about 1.5 times - but so are any losses. This is exactly what happened in 2023. The previously mentioned $324 million fair value write-down suffered in 2023 represented 23% of total assets at the start of the year, but a much more significant 34% of net assets - those attributable to the common stockholders. This loss was watered down by the portfolio investment income, but for investors is still very real and very painful.

High Fees

OXLC charges high management fees, and management's incentives, in my opinion, are not fully aligned with the interests of shareholders. Unlike an ETF these management fees are not readily produced in common data sources, and investors need to go digging in the annual reports to find them.

OXLC's 2023 annual report states the following:

The base management fee is calculated at an annual rate of 2.00% of the Fund's gross assets.

The incentive fee equals 20.0% of the excess, if any, of our Net Investment Income that exceeds a 1.75% quarterly (7.0% annualized) hurdle rate.

This is the classic "2 and 20" fee structure you might have heard of before: 2% of total assets and 20% of profits over a given hurdle rate, in this case, 7%. There are 4 reasons for investors to hate this fee structure:

1) The base fee is based on total assets, as opposed to net assets, which incentivizes management to raise as much capital as possible, even leverage up, at the expense of existing shareholders. If management raises an additional $100m in debt financing then they can earn an additional $2m in fees that year, while investors are stuck with the additional risk of leverage and cost of debt financing.

2) The incentive fee is solely based on "Net Investment Income" and has no relation to capital gains or losses. 2023 is the perfect example of where this works against shareholders. In a year where the shareholders make a reported loss of $171 million, management still gets paid a massive $38.4 million in incentive fees alone. Why? Because that $171m loss includes $320m of portfolio fair value losses. Net investment income (before incentive fees) was still a positive $191 million.

3) Finally there are no readily apparent clawback provisions for management and incentive fees in the event that OXLC shareholders suffer long-term losses. The incentive for management is clear: maximize immediate investment income.

The result of these factors discussed so far: the risk profile of the investment portfolio, the leverage being used, and the suboptimal incentive structure; as you might expect, is poor and evident in OXLC's long-term historical performance.

Total Return

On page 5 of OXLC's 2023 annual report, we find the following graph comparing OXLC's common stock total return (including dividends reinvested) and the S&P BDC index.

The figures provided show a cumulative 10-year return for OXLC's stock of 85.6%, or 6.4% annually. A positive return is great, but in the wider context of the investment universe, considering all possible alternatives, a less than 7% annual return is disappointing especially when considering it requires investors to operate in an obscure and complex corner of the market. For comparison, the S&P 500 total return (with dividends reinvested) would have provided a return of 217% over the exact same period.

A 12.2% annual return from the S&P 500 is almost double the return of OXLC and was provided without having to understand what a CLO is, and instead relying on the premier companies of the United States. Is it fair to compare OXLC to an S&P 500 index? Yes, I believe so. As investors, we absolutely should consider all possible investment alternatives and the opportunity cost associated with each. Ultimately, OXLC offers a higher-risk profile, and lower rewards in comparison to a cheap low-cost index fund.

Summary

If something sounds too good to be true it usually is and Oxford Capital Corp's 18% reported yield is no exception to the rule. Underpinning that massive yield is a complex, risky investment structure and poorly structured management incentives. Investors can and should leave the complexity associated with OXLC common stock out of their portfolio, and look elsewhere for profits and income.

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