2023-08-11 23:51:04 ET
Summary
- Oaktree Specialty Lending is a private credit actor with $179 billion AuM, with a flexible investment strategy.
- OCSL focuses on first lien loans but also holds a mix of second lien loans, mezzanine, unsecured debt, preferred equity, and equity co-investments.
- OCSL sees market opportunities in non-sponsored lending, sponsor-related financings, opportunistic private credit, and depressed public credit.
- Considering the high interest rate environment and difficulties for many corporates to access financing, the total opportunity set for OCSL has widened.
- Dividend yield of 11% seems safe in the context of sound underwriting principles and solid history. OCSL should be considered as a high yielding addition to investor portfolios.
Oaktree Specialty Lending ( OCSL ) is a private credit actor with a total AuM of $179 billion. Its investment or rather credit strategy is flexible and not constrained by the geographical, industry or other conventional aspects. Even the instruments held in the portfolio are not all associated with credit or fixed income. Roughly 10% is allocated towards equities and investments in JVs.
The overall investment objective of OCSL is to generate high streams of current income by leaving some room for a capital appreciation. Most of the focus is put towards first lien loans. Besides first lien, as of the most recent quarterly report, OCSL held 24% in a mix of second lien loans, mezzanine, unsecured debt, preferred equity and certain equity co-investments.
According to OCSL the current market opportunities lie in the following structures:
- Non-sponsored lending that are hard to analyse and value using conventional underwriting methods. In the market environment we are having now there is indeed a great opportunity set embedded in corporates, which require a rather exotic financing to either refinance or cover their CapEx ambitions, which have a lagged cash flow generation potential.
- Sponsor-related financings to accommodate leveraged buyouts of companies by sponsors that carry an expertise in certain industries. This is also a great segment, which is increasingly offering higher volumes of opportunities to assess and potentially channel financing. The higher demand stems primarily from the depressed equity valuations in small-cap segment, where it is inherently easier to conduct LBOs.
- Opportunistic private credit in sectors suffering from constrained access to liquidity. Since we entered in the high interest rate territory, there have been several sectors of economy suffering from increasing borrowing costs and uncertainty pertaining to the short to medium-term financial prospects. This coupled with tighter lending conditions has made it rather difficult for companies operating in office, retail, building, forestry (etc.) sectors to access sound financing irrespective of the status on covenants. As a result, companies like OCSL benefit from an increased total addressable market, where robust credit assessments can be made to funnel down to opportunistic risk and reward cases.
- Depressed public credit . This is also quite self-explanatory segment, which has since the outbreak of COVID-19 and early 2022 become attractive. The uptick in interest rates in conjunction with widening credit spreads have caused the YTM profiles to go up, especially in cyclical and interest rate sensitive segments.
Looking at OCSL's current portfolio we can see elements of a structural protection, decreasing the underlying risk profile.
Oaktree
OCSL has lent and / or invested in 156 companies in a relatively diversified manner. Namely, there is a relatively small concentration risk within OCSL's portfolio - both at single security and sector level.
The fact that the bulk of credits have been distributed in the first lien structures quite naturally helps further de-risk the exposure. Plus, 88% of the loans are senior secured.
Now, relatively recently OCSL published its Q3 results , which to a large extent confirm the aforementioned dynamics.
During the Q3 period, OCSL issued ~ $250 million in new loans (of which $191 million in loans to new portfolio companies) at a weighted average yield of 12.6%, which is ~150 basis points above the current yield. This implies a 40 basis points of an increase relative to the Q2, 2023.
If we look back at trailing five quarterly results, we can notice that during this Q3 the investment activity (or rather issued loan activity) was the highest both in terms of the volumes and yields. Again, this goes hand in hand with the argumentation that as of now OCSL has the right conditions to scope attractive deals that cumulatively should substantiate enhanced profitability on a go forward basis.
The thesis
So far we have established that the total addressable market or the potential opportunity set of OCSL to sign attractive lending deals has increased. In addition, we see limited concentration risk and a significant skew towards favourable credit structures (i.e., senior / first lien and secured loans).
In my opinion, there are three key drivers supporting the inclusion of OCSL in investor portfolios, were the focus is put on high yield and stable streams of income.
First , currently OCSL offers a very attractive yield of ~11%, which has gradually increased in the past three year period.
This implies a ~ 600 basis points of spread relative to the U.S. 10 year Treasury.
Also in the context of the general U.S. high yield corporate bond and high dividend paying stock universe, OCSL's yield seems very attractive. In fact, we can see that relatively recently the spread between OCSL's yield and that of the high yielding stocks and junk bonds has started to slightly widen.
Moreover, the lion's share of OCSL's loans are based on floating rates, which keep the upside potential from higher SOFR open. Granted, in case of a material interest rate decline, OCSL's loans would be subject to unfavourable repricing, thereby bringing the overall portfolio yield down. However, the offsetting factor in a such scenario would be the enhanced credit profiles of the underlying businesses, which would, in turn, de-risk OCSL's position.
Second , the 11% yield in combination of sound underlying portfolio renders the equity (or yield) story of OCSL attractive. As elaborated above, while OCSL is an opportunistic fund with a bias towards elevated risk transactions, the manner how these transactions and the total portfolio are structured keeps the risks in balance.
OCSL's dividend history also proves this that even during the pandemic period, there was no dividend cut assumed.
Third , the return prospects of OCSL seem solid considering the backdrop of potentially higher for longer scenario and companies finding it more difficult to access financing on optimal terms. In an environment like this, high-yield focused vehicles can thrive by finally enjoying a greater amount of supply (i.e., companies seeking unconventional financing).
Finally , I view OCSL as a beneficial addition to any portfolio, where the focus is put on the juicy streams of relatively stable cash flows. Nevertheless, considering the underlying nature of OCSL where elevated risk positions are sought after, there is inherently a considerable risk component attached stemming from the cases, which fall out of the conventional lending risk profile.
At this particular moment, the recessionary risks are rather present and the consequences of materially higher interest rates have not yet percolated through the economy (i.e., the lag effect). Plus, additional rate hikes are still possible, which would make the debt service of already 10%+ yielding loans more difficult.
In my humble opinion, it is worth considering OCSL as a nice addition to portfolio without assigning too high of an exposure.
For further details see:
Oaktree Speciality Lending: Portfolio Diversifier Yielding 11%