Summary
- We discuss quarterly results from the BDC Oaktree Specialty Lending Corp and highlight key income dynamics of the portfolio.
- OCSL delivered an 11% net income gain and raised its dividend once again.
- Portfolio quality remains stable and net income is set for another rise in Q1.
- We recently swapped back to OCSL after its valuation deflated somewhat.
This article was first released to Systematic Income subscribers and free trials on Feb. 14.
In this article, we catch up on the Q4 results of Oaktree Specialty Lending Corp (OCSL). The company continues to deliver net income gains and dividend hikes while keeping portfolio quality stable. OCSL trades at a 10.9% yield and a 2% premium to book. OCSL remains an attractive higher-quality BDC in our High Income Portfolio.
OCSL is primarily focused on secured loans with a low allocation to equity securities. Its sector overweights are software and healthcare - a fairly common combination in the BDC space.
OCSL
Quarter Update
Adjusted net income rose 11% to $0.61, primarily as a result of higher base rates.
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OCSL increased the dividend by a penny to $0.55, which was the 11th consecutive raise. Overall, the dividend was raised by 18% over 2022. OCSL make a big song and dance about their dividend being up more than 90% from its pre-pandemic level at the close of fiscal 2019, however, that's largely because of a high starting coverage level of 127%. Net income grew by half that amount since then - still very good but nowhere near the 90% figure.
With the new dividend, coverage falls to a still-high 111%, which leaves OCSL plenty of room to hike further, particularly as net income is expected to rise in Q1.
The NAV fell by 3.7%, however, 2% of that number was due to a special distribution, leaving close to 2% in unrealized depreciation .
As we highlighted before, OCSL has a relatively high NAV volatility for a credit-focused BDC for 2 reasons - its public loan holdings and what appears to be a more conservative mark-to-market approach of its private loan book. Over the last quarter, management said that the drop in public debt holdings was largely responsible for the NAV drag. Separately, management said that, over Q1, the NAV has already recovered by around 1% given the broad-based rally in the debt market.
The NAV has fallen for the fourth consecutive quarter and has underperformed the sector. We expect the typical turn to outperformance if markets continue to heal.
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Income Dynamics
The weighted average yield on new debt investments in Q4 was 13.1%, well above the 9.9% yield on new investments achieved in Q3. This looks to be a function of three things: a rise in base rates, a rise in credit spreads as well as a focus on higher yielding assets by the company.
This figure is also well above the 11.6% weighted-average yield, which itself rose by a full percentage point over the quarter as a result of a rise in base rates.
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Interest expense rose by more than 1% to 5.6%. This is a significant jump and is well above higher-quality peers like ARCC and GBDC whose interest expense is 4.2% and 4.4%, respectively. This higher level of interest expense for OCSL is largely a function of the low level of fixed-rate debt, making up only 20% versus around 50% for the average BDC. This structural feature keeps OCSL net income beta to rising short-term rates fairly low at 7% versus a 10.4% sector average.
Q4 was a big quarter for net new investments with a 6% rise.
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As a result, leverage increased, now being well above the 1.14x sector average. This is at the upper end of the target range of 0.9 - 1.25x, however, once the OSI 2 merger is through, leverage will shift lower to 1.16x.
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The merger will be a slight tailwind to net income. While overall portfolio yield will remain pretty similar (due to the 97% overlap between the two portfolios), the combined company will enjoy an estimated $1.6m in cost and operational synergies (~30% of total current general / administrative expenses) as well as a waiver of $9m in base management fees across two years (equivalent to about 75% of the combined quarterly base management fees).
Portfolio Quality
Non-accruals remained at zero.
There was a second quarter of small net realized losses , however, that compares favorably with a string of net realized gains over the previous couple of years. OCSL added around $21m of publicly traded CLO and ABS debt at an average price of 87 cents on the dollar. If these accrete back to par, it will provide a measure of realized gains to the portfolio. This ability to allocate to public sector securities is a fairly unique feature of the company in the sector.
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The portfolio's weighted average interest coverage declined slightly to 2.5x. This compares favorably to the anecdotal data from the rest of the BDC sector.
Management have indicated that legal terms and protections have improved in the second half of last year and loan-to-values have fallen, indicating a better underwriting environment.
Overall, portfolio quality remained stable and is, arguably, at the top end of the broader BDC sector.
Points Of Differentiation
In this section, we highlight the key "tilts" or structural features of OCSL and how they compare to the broader sector.
Oaktree is focused primarily on the upper middle-market area with a weighted-average EBITDA of $128m. This is in contrast to the majority of the sector and particularly BDCs like CSWC or FDUS that focus on the lower middle-market segment.
Second, Oaktree is one of the few BDCs that allocate to public debt as an investment strategy, including bank loans, CLOs and ABS. Oaktree has a broader credit umbrella which gives it the right know-how in allocating to these areas of credit markets. It also allows OCSL to be more tactical in sourcing attractive opportunities rather than having to wait for a new deal to come along which would take a significant amount of time to negotiate and close.
Third, Oaktree has a low equity allocation. This likely caps the amount of upside the company can achieve from exits of its holdings unlike a company like ARCC which has been able to extract additional gains on top of its credit portfolio. At the same time, it keeps downside limited as well.
Takeaways
OCSL delivered a decent quarter with a positive total NAV return and another dividend hike. The portfolio should generate a further rise in net income over the coming quarter which, alongside its high coverage, is likely to deliver another dividend hike.
We recently rotated back to OCSL from ARCC in our High Income Portfolio. At the time of the original OCSL to ARCC switch, OCSL was trading at a 5% premium to ARCC which looked expensive. Now that OCSL is trading at a 5% discount to ARCC (102% OCSL valuation vs. 107% ARCC valuation), we make the move back to OCSL. At the current valuation, OCSL remains attractive.
For further details see:
Oaktree Specialty Lending: Another Quarter, Another Dividend Hike For This 10.9%-Yielding BDC