To be read in conjunction with the BDC Summary Results Table for the IIQ 2024.

Oaktree Specialty Lending’s (OCSL) IIQ 2024 financial performance did not meet expectations and resulted in a 2 rating on our 5-point scale.

PREAMBLE

To date, including Saratoga Investment’s (SAR) quarterly results through May 2024, 6 BDCs have reported their latest performance. 4 have broadly met expectations where earnings, distributions, net book value change and credit are concerned. Those are – for the record – SAR, Ares Capital (ARCC); Sixth Street Specialty (TSLX) andNew Mountain Finance (NMFC). All those BDCs – with the exception of SAR – received performance scores of 3 or 4 previously so nothing very surprising that this has continued.

Not performing to expectations are Horizon Technology Finance (HRZN) and today Oaktree Specialty Lending (OCSL). We wrote about HRZN yesterday and will now tackle the Oaktree BDC below. Both these BDCs were rated 2 in the prior two quarters and again this quarter. This is a reminder that “turning around” a BDC once credit performance begins to sag – like the proverbial oil tanker – takes a great deal of time. Troubled companies don’t get to some sort of realization point overnight. Many of the underperforming portfolio companies on both BDCs books have been in distress for a year or two. (Over at our sister publication – the BDC Credit Reporter – we identify when a company first begins to underperform – data we find very interesting).

Everybody – from the analysts to the shareholders to the management of the BDCs themselves – want to know when the credit deterioration will end and a great deal of speculative stock trading occurs around this issue. One can tell a great deal from the valuation trend lines of existing underperforming companies. What is much harder to handicap is the sudden arrival of new distressed companies on the scene. That’s tough on investor and manager confidence. Unfortunately, this quarter both HRZN and OCSL have added new serious underperformers, pushing out the date of the eventual credit nadir.

PERFORMANCE

Yes, But

We’ll discuss OCSL’s credit performance a little later but let’s start with earnings, using the BDC’s favorite metric Adjusted Net Investment Income Per Share (ANIIPS). On paper, the $0.55 of ANIIPS seems to be a pretty good result – only slightly down from the $0.56 booked in the IQ 2024 and the $0.56 estimated by the analysts. However, the recurring earnings were boosted by a generous – but one time – incentive fee waiver by the external manager for ($3.2mn). Without that boost, ANIIPS would have been $0.51, well down from $0.62 per share peak earnings not so long ago in mid 2023 – an (18%) drop. Moreover, OCSL increased total yield bearing investments in the period, which also boosted income in this latest period.

Not Enough

Going forward there’ll be no incentive fee waiver but management has agreed to permantely reducing the management fee to 1% on all assets. That’s a shareholder friendly move, but those fees are already being waived currently on a temporary basis so don’t provide any incremental gain.

We’ve Got Questions

All this leads one to wonder how much longer OCSL can “cover” its $0.55 per quarter regular dividend. If not for that incentive fee waiver, the BDC would already be paying out more than its earning. Before we even get into a discussion of the impact of lower interest rates going forward, OCSL will have to contend with the lower spreads being earned on new loans, which is pressuring portfolio yields. Since the “Best Of Times ” in the IIIQ 2023, the “weighted average yield on debt investments” has fallen from 12.7% to 11.9%. There’s almost certainly further to go. This quarter new loans were being booked at a 11.1% yield.

Adding to the pressure on yield is management’s late-in-the-day strategic decision to seek out a greater proportion of first lien loans. Very roughly speaking a (1%) reduction in the yield on all loans could knock ($0.075) per annum off ANIIPS, after adjusting for incentive fees.

Book Value

Before we discuss any specifics, note that net realized and unrealized losses netted out to a loss of ($43mn) in the quarter.

Unfortunately – as the chart makes abundantly clear – this quarter’s loss was not only one in a series, but also the largest.(By the way, that monumental -$69mn realized loss was almost completely related to the restructuring of Thrasio, a company now owned by many BDCs thanks to a debt-for-equity swap. One day that may result in some sort of recoupment, but not now). New unrealized losses of ($59mn) were booked this quarter, 131% of net investment income earned.

Downer

With all earnings being paid out as dividends, all these losses reduced OCSL’s net book value on a dollar for dollar basis as this slide below from the BDC’s investment presentation makes clear:

As the NAV Change Table shows, OCSL’s Net Asset Value Per Share (NAVPS) has fallen (17%) since the end of 2021, including (2.8%) this quarter.

Miasma

Maybe this is a case of “It’s always darkest for the dawn”, but we can’t tell. We’ll have an opinion after the BDC Credit Reporter analyzes the entire portfolio and identifies any new troubled companies and what is happening to the known credit suspects. However, the news that the number of non-accruals on the books has increased from 5 to 8 and that non-performing assets at cost amount to 5.2% of the portfolio (5.7% of the debt alone) is discouraging. We’ve been rating OCSL’s credit performance as being BELOW NORMAL for some time and this only adds to our concern that underwriting is not up to snuff. Management argues that this is not a problem with the Oaktree platform, which is fair enough. These problems are said to be “idiosyncratic” but after how much time and how many failures does one concede that a new approach might be necessary? The sudden commitment by management to boosting its share of first lien loans in the portfolio may be a quiet admission that too much systemic risk was being booked…

In Danger

Through three quarters of OCSL paying out or announcing quarterly distributions of $0.55, the BDC is meeting the expectations of BDC Best Ideas, which projects out the likely annual payouts of (almost) every BDC till 2028. We’d expect OCSL to dividend out $2.20 for the full year, just slightly below the $2.27 achieved in 2023, but (10%)l below the $2.47 of the record year of 2022.

Drop Coming

Already, BDC Best Ideas – which has been presuming OCSL would lose (10%) of its NAVPS between 2023 and 2028 – was projecting the payout in 2025 would drop again in 2025 due to credit losses and lower rates. The estimate is for $2.00 next year – or $0.50 a quarter. The permanent fee reduction will mitigate some of the damage to earnings but can only help so much. Best Ideas is already mulling budgeting for an even bigger dividend reduction, but will wait till the Credit Reporter’s full review. In any case, OCSL’s current streak of paying out a $0.55 quarterly dividend 8 quarters in a row seems likely to end within a quarter or two. At an annual pro-forma payout of $2.00 per share, and at a stock price of $17.32, OCSL’s yield would still be 11.5% versus 12.7% currently. However, a more conservative estimate of $1.80 per share would knock the yield down to 10.4%.

CONCLUSION

There was little to cheer about in OCSL’s latest results and no sign that the BDC has turned any sort of corner. Still, there’s no panic showing at the manager and investors appear to be remaining calm even though OCSL’s stock price has dropped (25%) since January of 2022. The juicy distributions received of late have done much to cushion the blow of a lower stock price. According to Seeking Alpha, the 3 year total return is a still positive 23%.

Speculation

We wonder, though, how investors will react if and when the quarterly distribution gets cut shortly? Is that move already priced in or will investors – accustomed to rich dividends for the past few years – cut and run en masse? Much will depend on how successful management is at demonstrating that these credit and equity losses are just a string of bad luck and not the sign of a flawed underwriting process. We have no strong view on the subject – based on the data to date – but that might change as in the famous Keynes quote:

“When the facts change, I change my mind. What do you do, sir?”

John Maynard Keynes