2023-06-27 15:33:53 ET
Summary
- Business Development Companies (BDCs) offer high income flows for investors by pooling money and investing in small and medium-sized companies, often with high interest rates on loans.
- Oaktree Specialty Lending Corporation is a BDC with a $3.2 billion investment portfolio, providing investors with strong income and decent growth since 2007.
- OCSL's diverse portfolio, growing dividend, and disciplined management make it a solid BDC for income-oriented investors, despite potential risks from economic decline or rising interest rates.
For investors looking for high income flows, Business Development Companies (BDCs) are arguably a great option to fulfill that income need. What are BDCs and why are they a good option for income investors? Generally, BDCs are a type of closed-end investment fund, and they are registered as a BDC under the Investment Company Act of 1940. BDCs pool money from investors and then invest that money in small and medium-sized companies (usually private). These companies are often in the developing stage, or they may be in some type of financial distress. As a result, they usually do not have access to funding through other means, so BDCs are there to fill the role. Usually, the BDCs invest in first- and second-lien debt of these companies, but they can also make equity investments as well. Because of the nature of these types of investments, the interest rates on the loans are usually fairly high, well-above the typical corporate or government rated interest rates.
Furthermore, BDCs are usually registered as a Regulated Investment Company ((RIC)) for U.S. federal income tax purposes. As a RIC, the BDC will generally not have to pay corporate-level U.S. federal income taxes. To qualify as such, the company must meet several requirements, one of which is to distribute to the shareholders at least 90% of the company’s taxable income, which is generally calculated as the ordinary income plus the net realized short term capital gains less net long-term capital losses. Because of the specific registration and its unique requirements, BDCs return a lot of income to investors, which makes them a great option for income-oriented investors. The tax details, like most things concerning taxes, can be very complex, so it is important to consult your tax advisor before investing in a BDC.
BDCs receive a lot of attention on SeekingAlpha , likely due to their increased popularity and their potentially high income flows. One BDC that has been a mainstay in my portfolio for a while is Oaktree Specialty Lending Corporation ( OCSL ). OCSL is managed by Oaktree Fund Advisors, LLC, which is part of the Oaktree Capital Group LLC. Oaktree, of course, is led by the brilliant Howard Marks, who I think is one of the smartest guys in the room. One look at Oaktree’s website and their philosophy is laid out in very plain terms:
- Risk control
- Consistency
- Market inefficiencies
- Specialization
- Macro forecasting not critical
- No market timing
Not surprisingly, OCSL is designed within each of these principles. OCSL is focused on providing companies with flexible and innovative financing solutions. Their expertise allows them to be able to generate win-win solutions for their portfolio companies as well as for investors. Currently, the company has a $3.2 billion investment portfolio , made up of 165 companies and an average yield of 11.9%. These founding principles coupled with a diversified portfolio are what has enabled OCSL to provide investors with decent growth and strong income since its founding in 2007.
When examining a financial company, particularly a BDC, there are a few things I like to focus on to arrive at an investment decision: the portfolio characteristics, the ability to continue to distribute income at the prevailing levels and the valuation.
The portfolio is essentially the most important aspect of the BDC to examine when considering it as an investment. As of the end of Q2 2023 , OCSL had an investment portfolio of $3.2 billion. This is quite a bit larger than the prior year as OCSL merged with Oaktree Strategic Income II, a similarly managed company with a high level of overlap in its investment portfolio. The portfolio is comprised of primarily debt securities, with additional investments in equities, debt JVs and equity JVs.
Oaktree Specialty Lending Corporation 10-q
The debt portion of the portfolio is comprised of floating-rate notes, which is very important during rising interest rate environments:
Oaktree Specialty Lending Corporation 10-q
With interest rates on the rise, much of the risk is mitigated as most of the portfolio will see higher interest rates as well. This is important as we will see later because the funding for these investments is getting more expensive, too.
Additionally, the investment portfolio is comprised primarily of senior secured debt. This is beneficial for the company and investors if an issue arises with a portfolio company that is either unable to pay its interest or its debt.
Oaktree Specialty Lending Corporation 10-q
It should be noted that these portfolio allocations have remained fairly consistent over the past five years. Five years ago, debt investments were 86% of the portfolio, floating rate debt was 83% and senior secured debt was 75%. The numbers have trended in what I would call a positive direction, but it basically goes back to the risk and consistency principles that were alluded to earlier.
Finally, the investment portfolio is very diversified, with the top-5 largest sectors taking up just over one-third of the entire portfolio.
Oaktree Specialty Lending Corporation 10-q
It should be noted that the “All other” category in the above chart contains investments in over 50 industries.
This diversification has proven to be successful for the company, and it is extremely beneficial during today's difficult economic conditions. In the company’s second quarter earnings call , management discussed two investments that are in “non-accrual” status. Interest income is recorded on an accrual basis to the extent that the income payments are expected to be received. When the interest payments or principal payments are in doubt, the investment is placed on a non-accrual basis until the company is back on a path to repaying interest and/or principal. One investment, “The Avery” is a luxury real estate development property in San Francisco. Management indicated on the earnings call that the company was receiving payments while new units were sold, but apparently the sales have slowed dramatically in recent months/quarters. The company is working with the investment company to modify the outstanding loan and facilitate the sale of the building in order to get the cash back sooner. The total investment is $23 million and was marked to 98% of par at the end of the quarter. As a point of reference, the real estate operating company sector made up just 2.4% of total investments at the end of the quarter.
The other non-accrual was for an investment in an advanced material sciences company, SiO2 Materials Science. SiO2 made significant investments during COVID, but has had some challenges in returning to a post-COVID normalcy. OCSL is working with SiO2 on a restructuring, which will help right-size the company appropriately as well as enable OCSL to receive its investment. The total investment of $50 million was marked to 88% of par at the end of the quarter. This is basically the only investment in the metal and glass sector, which was less than 2% of total investments. Management seems to be confident that both of these situations will be worked out, one way or the other. I am very comfortable that Oaktree's experience and specialty in working with restructurings is a competitive advantage, and these two non-accruals will be worked out successfully for everyone involved.
In the latest quarter, the company committed $124 million across nine investments. Both of these figures are relatively light, in fact the fewest number of deals in a quarter since at least 2020. Management indicated on the earnings call that they can be selective in this type of environment, which points back to their principle of risk control. As an example, management said there were plenty of second-lien opportunities available during the quarter, but the risk-reward trade off compared to first-lien opportunities was not favorable, so they committed to only first-lien investments. I like the discipline exhibited in this situation.
Finally, the last word on the portfolio. The weighted average yield of investments in the portfolio was 11.9% at the end of the second quarter. The weighted average interest rate charged on borrowings is about 6.2%, which means that the margin spread is about 5.7%, down from the end of 2021 when it was about 6.3%. However, it is still very healthy and with interest rate increases hopefully nearing the end of the cycle, this spread should be maintained at or near these levels.
This large, diverse portfolio has produced the capability to generate very healthy distributions over the years. As explained earlier, the company is registered as a BDC and is required to distribute at least 90% of its taxable income to shareholders. The following table highlights the company’s adjusted net investment income and distributions for the past three years:
2020 | 2021 | 2022 | YTD '23 | |
Adj Net Investment Income / share | $1.53 | $1.89 | $2.11 | $1.23 |
Distributions / share | $1.17 | $1.515 | $1.95 | $1.09 |
Payout ratio | 77% | 80% | 92% | 89% |
Source: Company 10-k
Management commented during the Q2 earnings call that the payout in the second quarter was somewhat conservative, but this overearning helps to grow the NAV as well. So, despite the company holding the dividend flat(ish) for the quarter, it is still a solid payout with a very high yield. There is no reason to believe that the dividend at these levels is not safe, barring some unforeseen disaster in the credit markets. The company managed to increase the payout during 2020 and 2021. In fact, the distributions per share have increased at a 6.9% CAGR over the past five years. Dividends growing at 7% annually? I will take that any day.
Finally, this leads us to the valuation. BDCs, like most financial companies, are comprised primarily of financial assets and financial liabilities. Therefore, the company’s book value is an appropriate metric to examine to help determine whether the company is a good value. All things equal, it is better to pay less than book value for a financial company. At the end of the latest quarter, the company’s book value per share stood at $19.66, up slightly from the prior quarter, but down from a year ago.
The company issued almost 16 million shares in the second quarter in connection with the OSI2 Merger, somewhat diluting the book value. However, the book value has increased at an annual clip of about 2% over the past five years. At a recent price of $18.67, the stock is trading at a P/B ratio of 0.95x.
This discount to book value (or NAV) helps to increase the yield as well. The yield on book value is 11.1% while the yield on price is 11.7%. Furthermore, the average peer BDC trades at a P/B of 1.1x, with an average yield of 11.7%.
The stock has some room to grow to get to an average price to book, while its yield is consistent with BDCs of similar market cap.
There are most certainly other BDCs out there that might be more attractive right now. But for me, with the backing of Oaktree Capital, I find OCSL to be a great component of my income generating portfolio. A growing dividend, a growing book value and high-quality, disciplined management team are really all I am looking for when considering a BDC. There are some risks, of course, particularly if the economy goes into a more widespread decline or if interest rates continue to increase, which will increase the cost of capital. However, with a floating rate portfolio, the risk of higher interest rates is largely mitigated. I think the bigger risk is if a widespread decline in the economy results in the company putting more investments in the nonaccrual status, thereby decreasing income and cash flows. However, for the time, I believe OCSL is a solid BDC which will help with an investor’s income producing demands.
For further details see:
Oaktree Specialty Lending Corporation: Look No Further For A Best-In-Class BDC