Oaktree Specialty Lending : Kitchen Sink Or More Trouble Ahead ?
Are We Done Here ?
When Oaktree Specialty Lending (OCSL) announced its fiscal fourth quarter and full year results for the periods through September 30, 2017, Seeking Alpha‘s headline was “New management kitchen-sinks OCSL quarter”. On the ensuing Conference call – where the new Oaktree overseers responded to questions from analysts for the first time – kitchen sink throwing analogies appeared to be on the mind of the questioners. Several analysts asked – in different ways – if the new Investment Advisor had been more conservative than the prior Investment Advisor. As the BDC Reporter had been musing before the earnings were released, many market participants expected Oaktree to be unusually rigorous in how assets were valued given that they bear no responsibility for any poor performance and might be able in the future to mark up assets and point to their track record of increasing Net Asset Value. Apparently many investors assume financial gamesmanship is a given in these situations.
The new Investment Advisor did not admit any such thing (how could they ?) on the Conference Call, pointing out that both their own personnel and prior FSC managers were involved in the evaluation process, as well as third party valuations firms and the Board itself (with whom the final determination sits from a regulatory standpoint). On a couple of occasions, Oaktree noted that the substantial increase in Unrealized Depreciation of the BDC’s portfolio between the fiscal third quarter and fourth quarter was concentrated in a few names where new negative information emerged in the period.
Overall Unrealized Depreciation on the balance sheet more than doubled from one quarter to the next: from $99mn at June 30 to $216mn by September 30. Moreover, the BDC also wrote off ($20mn) of Realized Losses, a number that would have been even higher were it not for two large – and atypical for FSC/OCSL – Realized Gains. In total, Oaktree booked ($137mn) of losses. To put that into perspective that’s equal to 4 quarters of Net Investment Income at the current pace. Fifth Street Asset Management‘s legacy formally ended with $1.6bn of equity capital raised and over ($700mn) of Realized and Unrealized Losses and over distributed net Investment Income (return of capital). No wonder investors want to be reassured that the nightmare of the last several years is over. A table in the 10-K illustrates how poorly FSC/OSCL has performed. For EVERY quarter in the past 3 years the BDC has recorded a loss when the Realized and Unrealized numbers are added together. See page 161. And weep.
Nor was the horror limited to book value either in this quarter or the past. On an annual basis over the past 5 years – as the 10-K shows on page 55 – Net Investment Income Per Share has dropped in half. Moreover, with the fiscal IVQ reported Net Investment Income Per Share of $0.08, the “running rate” has dropped by more than two-thirds since FY 2013.
Which brings us back to where we started: has OCSL reached a bottom with Net Investment Income Per Share annualizing at $0.32 and NAV Per Share at $6.16 ? At first, the market – which had been moving down in the weeks before the results were announced – appeared to be satisfied that a “bottom had been reached”. The stock opened at $5.09 (after closing at $5.20) and closed at $5.03 on the day of the release-Wednesday November 29. As we write this, though, some doubt appears to have crept in with the day’s range $4.78-$5.02.
The BDC Reporter has reviewed the 10-K and read the Conference Call transcript a couple of times. See above for both documents. We’ve looked at the portfolio list – recognizing many of the Usual Suspects on the non-accrual list which the BDC provides great disclosure about (one of the few positive aspects of the FSAM tenure). We’ve not yet done a company-by-company review of every Watch List name as we sometimes undertake when we have ten or twenty hours to burn. Nonetheless, our conclusion is that the seemingly endless slide in OCSL’s key metrics – notwithstanding the huge write-offs taken this quarter and the record low recurring earnings – may have further to go. Even with Oaktree at the helm rather than FSAM.
We’ll refer you to that much used analogy of the difficulties of turning around a super tanker in a hurry. We hear from maritime folk that’s a well nigh impossible task and Oaktree has a similar problem. In fact, the new Investment Advisor wisely dodged providing any timetable for its proposed “repositioning” of the BDC’s portfolio. “One year?” an analyst asked. Oaktree would not be drawn, but did suggest that some of the heavy lifting/shifting might be accomplished earlier than might have been expected. This will involve selling off where possible smaller performing positions and liquid syndicated loans (which FSC bulked up on to keep investment income flowing while the change was being made at the helm). The troubled loans will either be turned round if that’s deemed a plausible exit AND the Investment Advisor has the control necessary to direct such an action. (We count only 3-4 possible names in the Oaktree restructuring wheel house and even some of those seem too far gone to merit the attention). Other non-performing and under-performing loans and investments will be disposed of where possible.
By The Numbers
We count – at the moment – 12 Watch List names (3 under-performing and 8 on non-accrual- up from 6 the quarter before- and the Senior Loan Fund JV). That’s out of an on balance sheet universe of 82 entities (including the JV). Plus, there are at least 3 smaller under-performing equity or fund investments. Unfortunately except for a small remaining equity stake in Yeti Acquisition, LLC (great coolers) marked at $4.9mn at FMV, there seem to be no “harvestable” equity stakes.
On an aggregate basis these problematic loans and investments (not including the JV) amount to $253mn. Of course neither the BDC Reporter nor even Oaktree itself has any idea of how much of that quarter of a billion might yet be written down or off, if any. However, based on looking at each name in turn and given that most of the credits are already on non-accrual, we cannot be optimistic. There is a very great concentration in Healthcare and Technology/Software. This is a matter of much definitional debate. When we used the broadest definition of those two industries we calculated that nearly half of assets at FMV fall therein. That’s reason to be concerned as the credit record of these loans has been poor, and recovery rates (regardless of whether first lien or second lien) just as bad.
To put this into perspective a 50% further write-down in the FMV of these troubled assets would reduce NAV Per Share by another ($0.89), bringing down the number to $5.27.
Off The Books
Then there’s the Senior Loan JV. Oaktree was not exactly forthcoming about what’s happening at OCSL’s venture with a subsidiary of Kemper. However the BDC Reporter has noted previously that the filings suggested that not all is well. The latest results show that earnings are down, total assets greatly reduced and an Unrealized Loss in the investment recorded. A couple of portfolio companies amidst the 32 in the JV had problems, which has hurt both profitability and valuation. A conservative approach would be to assume that the current negative trends are likely to continue, especially given that most of the loans in portfolio are identical to the rest of OCSL’s portfolio and heavy in those two industries we mentioned.
So we worry that there is still risk of further book value write-downs as the portfolio gets re-positioned. We have not even dared to consider what might be the impact if some currently performing loans slip up. OCSL still has a plethora of high yield, high risk second lien loans on the books. Oaktree or no Oaktree, if any of those borrowers get into trouble, things could get worse. A year out – and assuming no new troubles – our more conservative assessment is that OCSL’s NAV Per Share could drop to $5.0-$5.50 a share.
Equally worrying is what might happen to the metric which means the most to BDC valuation: recurring earnings or Net Investment Income Per Share. Unfortunately, most of the trends affecting profitability are headed south. First, there is the impact from 8 non-accruing loans, up from 6 and 4 the year before. Then, there is unlikely to be any relief from adding incremental new assets given that debt to equity leverage is at 0.78x already as of September 30 and could get worse if we’re right about future losses. Moreover – without giving any guidance – Oaktree suggested that they like to be careful about taking on too much leverage, so we might see total investment assets (and thus income) drop further.
On Paper Income
We also should point out that a good portion of even the latest Investment Income is in Pay In Kind Form. As the 10K itself admits, in those Risk Factors (see page 39) which nobody reads, that income may be taxable to investors but is typically not received till maturity of a loan (if at all) which may be 5-7 years away. OCSL has accumulated $69mn in unpaid PIK. Last year alone $19mn of PIK income was accrued from the existing portfolio but only $4mn was collected in cash form. The BDC Reporter’s calculation of Net Investment Income Per Share, net of PIK, is 75% of the reported number. To our way of thinking – and we are not even discussing other non-cash income sources – the “real” Net Investment Income Per share in the last quarter of the year might have been as low as $0.06 or $0.24 annualized.
Then there’s the BDC’s cost of debt. In recent months OCSL has both paid off the BDC’s inexpensive SBIC funding for regulatory reasons and its Sumitomo Revolver. As a result, the average cost of debt is rising as the BDC relies ever more heavily on a proportionate basis on its more expensive Unsecured Notes, including the two Baby Bonds listed in our Fixed Income Table. Even if these eventually get refinanced at a lower rate (which is the current trend regardless of issuer performance), the savings are unlikely to be material given that FSAM had already raised the debt at advantageous rates.
Not helping the situation is the what we will call un-generous approach of the Investment Advisor towards compensation expenses going forward. As we discussed in earlier posts when Oaktree took over as Investment Advisor, the new manager has established a relatively expensive fee structure. There is a 1.5% Management Fee and a 17.5% Incentive Fee after a very low threshold of 6.0% Preferred return is reached (that bar is dropping). There was no Incentive Fee due this quarter. However in future periods, should OCSL boost its earnings up modestly all or most of any progress will be paid to the Investment Advisor. Moreover, given that Oaktree deep-sixed the Total Return provision that FSAM had grudgingly agreed to, incentive compensation could get paid even as NAV and the distribution continue to drop.
Unlike many other Investment Advisors who have waived fees in one way or another when shareholders are being dunned by lower book values and distributions, Oaktree has not (as yet) offered up any goodwill gesture. If the Investment Advisor does not raise its hand in this regard, the first 17.5% of Net Investment Income increase is likely to go to the manager’s coffers rather than to soften the blow of perpetually lower earnings for shareholders.
The new Investment Advisor – deliberately or otherwise – has taken a big broom to the valuation of its newly acquired portfolio and given investors little illusion that book value and earnings have been terribly damaged by FSAM’s poor management. That notwithstanding, the BDC Reporter is not convinced that there might not yet be material further drops ahead in book value and – most importantly – in the course of future earnings. Both the legacy left by FSAM – who received $320mn for offloading its management contract with nary a complaint from shareholders, analyst or regulators- and Oaktree’s chosen business model suggest that things are likely to get worse at OCSL before they get better. For our formal Dividend Outlook, which we update following every earnings release, see below.
At time of writing, OCSL has not announced a distribution for the first calendar quarter of 2018. However, on the Conference Call the Investment Advisor indicated a variable quarterly pay-out was envisaged, which would be pegged to current earnings. This alone suggests that even the Investment Advisor is unsure of what income is going to be in the months ahead. Eventually – after the repositioning is complete or on its way – Oaktree proposes to return to a fixed dividend policy.
The BDC Reporter, though, projects that the latest dividend iteration of $0.125 (which was announced in August and will be paid in December) will not be maintained in 2018. As a result, OCSL’s Dividend Outlook is for a DECREASE. (We will guess that the distribution will annualize at somewhere around $0.32-$0.35).
We have no position in OCSL’s common stock, nor any intention of acquiring any even in our Special Situations strategy. At its current price the stock remains far too expensive by our lights given the myriad uncertainties described above.
The BDC Reporter will only add OCSL to our Watch List if the price drops below $4.0.
Given the BDC’s track record with FSAM and Oaktree very short tenure and uncertain strategic approach, OCSL does not figure even as a prospect on our Long Term Income list.
We are Long both of the BDC’s publicly traded Baby Bonds with the tickers OCLE and OCSLL.
OSLE may be redeemed at anytime and OCSLL from 4/30/2018, just 5 months away. Both yield around 6.0% at current prices, which are typically 1% above par.
We bought into OCLE in the spring (previously FSCE) when the market expected a redemption at the earliest possible date: October 31, 2017. As a result, the Baby Bond was trading close to par.
That redemption has not yet happened and we will take the risk of being called and continue to hold our position for the foreseeable future.
There’s a similar narrative where OCSLL is concerned. We will continue to hold what is BBB rated debt.
If either Baby Bond dropped to par, we are likely to add to our positions, which we hold in several portfolios.Already a Member? Log In
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