Oaktree Specialty Lending Corp
NASDAQ:OCSL
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Oaktree Specialty Lending Corp
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Welcome and thank you for joining Oaktree Specialty Lending Corporation’s Third Quarter 2018 Conference Call. Today’s conference call is being recorded. At this time, all participants are in a listen-only mode. [Operator Instructions]
Now, I would like to introduce Michael Mosticchio of Investor Relations, who will host today’s conference call. Mr. Mosticchio, you may begin.
Thank you, operator, and welcome to Oaktree Specialty Lending Corporation’s third quarter 2018 conference call. Both our earnings release, which we issued this morning and the accompanying slide presentation, can be accessed on the Investors section of our website at oaktreespecialtylending.com.
Our speakers today are Oaktree Specialty Lending’s Chief Executive Officer and Chief Investment Officer, Edgar Lee; Chief Financial Officer and Treasurer, Mel Carlisle; and Chief Operating Officer, Matt Pendo. We will be happy to take your questions following their prepared remarks.
Before we begin, I want to remind you that comments today will include forward-looking statements reflecting our current views with respect to, among other things, our future operating results and financial performance. Our actual results could differ materially from those implied or expressed in the forward-looking statements. Please refer to our SEC filings for a discussion of these factors.
We undertake no duty to update or revise any forward-looking statements post after today’s call. I’d also like to remind you that nothing in this call constitutes an offer to sell or solicitation of an offer to purchase any interest in any Oaktree fund. Investors and others should note that Oaktree Specialty Lending uses the Investors section of its corporate website to announce material information. Accordingly, the Company encourages investors, the media and others to visit our corporate website to obtain investor related materials.
With that, I would now like to turn the call over to our Chief Executive Officer, Edgar Lee.
Thank you, Mike, and welcome everyone to our third quarter 2018 earnings conference call. We appreciate your continued interest in OCSL and your participation in today’s call. Our primary focus since Oaktree acquisition has been to stabilize and reposition our imperative portfolio by editing non-core assets, while expanding the amount of core assets in the portfolio. We continue to closely monitor the direct lending landscape for new investment opportunities that align with Oaktree’s underlying philosophy of controlling downside risks.
The ultimate goal of these repositioning efforts is to improve ROE for our shareholders. We have made significant progress and repositioning our portfolio and stabilizing NAV since we began managing OCSL last October. Over a period of just nine months, we have refinancing and repayments of almost $1 billion of assets in our portfolio. During that same time, we've reduced our non-core asset exposure by 60% or $536 million. At the end of the third quarter, only 26% of the portfolio at fair value remained in non-core investments, many of which have been demonstrating stable operating trends.
It is especially noteworthy that $536 million of the non-core assets we exited were spread across 55 individual positions, many of which were illiquid and challenged. In addition, we exited the vast majority of these investments either at PAR value or above their previous fair value marks, demonstrating our ability to maximize value for our investors. I am very proud of our team's hard work and successfully monetizing these assets.
Over the same period, we also doubled the amount of core investments that we hold as we added nearly $786 million of new investments across 52 companies to the portfolio. $380 million of these new assets were added in the third quarter. As of June 30th, core investments totaled over $1 billion in market value and represented approximately 75% of our portfolio.
I am pleased with the outcome of our repositioning efforts, which includes the stabilization of our portfolios NAV. During the third quarter NAV increased for the second consecutive quarter to $5.95 per share, up from $5.81 at the end of December.
As of June 30th, the portfolio had a fair value of $1.5 billion invested across 116 companies, approximately 53% of the portfolio was invested in first lien loans, 23% in second lien loans, 11% in unsecured bonds, 9% in the Kemper JV and the remaining 4% in equity or limited partner interest. 83% of our debt investments had floating interest rates.
As previously indicated at the end of the third quarter, almost 75% of the portfolio was comprised of core investments. Another 18% was non-core yet still performing and the remaining 8% was non-core and underperforming.
We expect to continue exiting non-core assets at a robust pace while also maximizing value for investors. Of our $357 million non-core portfolio, we anticipate over half of these investments will be liquidated over the next few quarters as many of these investments are liquid loans or are in active sale or refinancing processes.
We expect to hold approximately a quarter of these investments over a longer period as these portfolio companies are generally performing well, and we intend to opportunistically exit these positions when we believe their values have been optimized.
With respect to remaining investments, we are actively working with management teams and the financial advisors to implement asset sales, balance sheet restructurings for other monetization events.
During the quarter, we exit our investments in Metamorph and Traffic Solutions and received the final proceeds from the sale of Ameritox. We also made significant progress reducing our equity and limited partnership interest as we sold $34 million of these assets during the quarter.
Importantly, we monetized these positions at or above their fair value marks underscoring the proactive approach we have taken in managing underperforming credits. Given Oaktree, deep restructuring experience and expertise, we led the sale processes of these transactions which allowed us to maximize recovery values.
With respect to our remaining underperforming investments, we believe the marks on these investments reflect their fair value given each company’s underlying business trends many of which are showing signs of improvement. We have received a number of bids for these assets and therefore we are cautiously optimistic that it could lead to further upside and recovery values.
Turning to the current market environment, there is a tremendous amount of capital being raised to target direct lending opportunities. This is created a highly competitive borrower friendly climate where direct lending funds and BDCs are aggressively competing in the private equity back segment of the market. As more capital has flown into the direct lending space, investments have become more commoditized, leading to spread compression and less attractive covenant structures across the board.
We continue to observe frothy evaluations and an increased appetite for risk and the cycle, which is long by historical standards in spite of the absence of widespread credit deterioration. Against this backdrop, we are currently focused on defensively positioning the portfolio by investing in larger, more seasoned businesses that operate in non-cyclical, defensive or structurally growing industries.
We remained committed to our long-term strategy and will continue to evaluate opportunities in both the sponsor and non-sponsor owned segments of the market that we believe will generate the best risk adjusted returns over the long-term. We are taking the highly selective and patient approach to evaluating potential investments and maintaining investment discipline.
Although this approach is muted, the overall yield on new investments, we believe a more defensive posture is the best way to generate income in the near-term. All told, I’m pleased with the significant progress we’ve made since we began managing OCSL nine months ago, and believe we are very well positioned to navigate evolving market conditions to deliver attractive returns to our shareholders.
I’ll now turn the call over to Mel Carlisle to review our financial results in more detail.
Thank you, Edgar. We had a good quarter, and we are pleased with our improving financial performance. Net investment income in third quarter was $14.4 million or $0.10 per basic and diluted share. This was down slightly from $15.3 million or $0.11 per share last quarter. Mainly due to reduce investment income and partially offset by lower interest expense. Total investment income for the quarter was $31.8 million, down from $34.8 million in the March quarter. This was primarily due to decreases in PIK interest and both fee and dividend income.
The decrease in dividend income was partially due to the Kemper joint venture, not paying a dividend this quarter. I will discuss our Kemper joint venture and more details shortly. Cash interest income was flat for the quarter despite a slightly larger portfolio. This was mainly due to a quarter-over-quarter decrease of $1 million related to an investment placed on non-accrual status and a $400,000 decline in original issue discount income due to zero loan repayments during the quarter.
In addition, a significant number of modest conditions occurred at the beginning of the quarter, we reinvested those proceeds towards the end of the quarter creating a drag on interest income. These items are partially offset by higher rates following to the LIBOR reset in March. Interest expense declined approximately $250,000 in the third quarter mainly driven by lower average borrowing and partially offset by higher average interest rates. Net operating expenses for the quarter were $9.1 million, down from $10.9 million from last quarter reflecting lower professional fees, G&A expenses and incentive fees.
Now turning to credit quality. At June 30th, 4.6% of our debt investments at fair value were at non-accrual status. One investment currently valued at $38 million was moved to non-accrual status following a payment default in the third quarter. At June 30th, we've wrote down the value of this investment by an additional $4 million marking into approximately 73% of cost. We are in communication with this borrower and a recapitalization plan is underway. There were no other material write downs and net unrealized appreciation was $1 million for investments held at the end of the quarter.
Net realized gains for investments exited during the quarter for $8 million, as majority of our investment sales during the quarter were above their March 31st fair value mark. As Edgar mentioned, net asset value increased for the second consecutive quarter to $5.95 per share at quarter-end, this compares to $5.87 per share at March 31st.
On Page 12 of the earnings presentation, we've provided a bridge that explains key factors that led to the in NAV. At June 30th, total debt outstanding was $607 million at a weighted average interest rate of 5.5%. Our leverage ratio increased slightly to 0.73x from 0.71x at March 31, reflecting higher borrowings on our credit facility at quarter-end.
In July, we amended our credit facility with ING. As part of the amendment, we've reduced our interest rate on amount strong by 25 basis points. At quarter end, cash and cash equivalents were $57 million and we have $389 million of undrawn capacity on our $600 million credit facility. Unfunded commitments outstanding at quarter-end were $64 million mainly related to portfolio companies with revolving credit facilities or delayed draw term loans.
Before I turn the call over to Matt, I want to provide an update on our Kemper joint venture. During the third quarter, we continued to optimize the JV adding $91 million of new investments across 10 companies with a weighted average yield of 6.6%. At June 30th, the JV had total assets of $357 million, a leverage ratio of 1.1x and a credit facility with $35 million of undrawn capacity.
We expect to continue to expand our debt capacity overtime, as we add first lien senior security investments to the portfolio. Also during the third quarter, we amended and restructured our credit facility, under the Kemper JV. We reduced the interest rate on the facility from LIBOR plus 225 basis points to LIBOR plus 185 basis points.
We extended the term by three years and achieved favorable advanced rates and concentration limits. We also restructured the class B note from 15% payment in kind from 10% cash pay. This will eliminate PIK interest income related to the Kemper JV going forward.
Now, I will turn the call over to Matt Pendo, our COO.
Thank you, Mel. Since the end of the last fiscal year, we have successfully rotated out of over $60 million of non-interest generating investments including equity, limited partnership interest and non-accrual loans. This amount includes $14 million from the sale of the majority of our limited partnership interest in the third quarter. Importantly, these were sold at a slight premium to the net asset values. As of June 30th, we had a $135 million remaining in non-interest generating investments spread across 42 companies and four LP positions.
We continue to benefit from rising interest rates in the third quarter given that our portfolio consist primarily of floating rate assets, with a monthly fix rate liability structure. We expect to see more benefits, if there are additional rate increases this year. As Mel highlighted, we continue to optimize our Kemper JV. During the quarter, we grew the joint venture to $357 million of total assets and lower borrowing costs by 40 basis points. As we grow the joint venture, we expect it will be further accretive to ROE.
Finally, during the third quarter, we have responded to market conditions by temporarily increasing our exposure to broadly syndicated loans to $57 million, as of June 30th. We are investing in more liquid loans in order to earn spread income until we can deploy capital into higher yielding proprietary investments that we want to hold over the long-term. We felt this was an appropriate type of move and not a change in our strategy.
Taking a prudent and selective approach to investing is paramount in the current environment. As such, we are confident that by leveraging the Oaktree platform, we’ll be successful in originating and structuring attractive transactions that ensure downside protection, a hallmark of Oaktree’s investment approach and deliver higher yields without assuming additional risk.
Now turning to our dividend, as you saw in our press release, we declared a $0.095 dividend today. This is unchanged from last quarter and represents approximately 93% of the net investment income earned in the third quarter.
In conclusion, we are pleased with the significant progress we have made in repositioning the OCSL portfolio and stabilizing NAV. Our team is executing well against all of our key initiatives and we are making strong progress against our long-term goals, delivering high single digit ROE and a consistent dividend.
Thank you for your time and attention today, we look forward to keeping you updated on our progress. And with that operator, please open up the lines for questions.
We now begin the question-and-answer session. [Operator Instructions] Our first question will come from Chris York of JMP Securities.
Maybe Edger, could you provide us an update on your thoughts for pursuing leverage above your current target of 0.85x, give me a progress of exiting non-core investments? And then the portfolio growth this quarter, which Matt did say included some DSLs and then also expand leverage?
Thanks for the question, Chris, and good morning. Right now, we don't have any intensions to adjust leverage at this time, but together with the board we continue to evaluate our leverage position and where we may take that overtime. Right now, we're comfortable with the current leverage position and we feel that we have ample capacity on our existing facilities as we’ve only levered 0.73x right now as well as we have capacity in our Kemper joint venture. Having said that, we're considering number of different factors and weighing those as we consider what to do with respect to leverage long-term and those also include our cost to capital and the impact on our credit ratings.
Alright thanks for the update. See weighted average yield, I'm looking to try to get that number for your exits. We've got 8.1 per yield on new investments and I'm conversely trying to find the number. I probably looking pull it off, but maybe Mel, do you have that for us?
8%. The yield on the exits was 10%, sorry.
Yes, that makes some sense. And then I'm aware that Allan Media in the market with Deutsche and Jefferies seeking new term financing. So do you expect to be refinanced of your term loan this quarter?
The transaction with that has been contemplated by Allan Media in the marketplace today hasn't closed yet. Should they raise the capital that they’re seeking to raise, we'd anticipate being refinanced out of that loan.
And then the mark at quarter-end in my view doesn't imply any prepayment penalties or premiums associated with that. Is that fair?
That's what I would say, we don't typically comment on the structures of our loans due to certain confidentiality provisions. But as a general matter, I would say that all of our proprietary loans typically have a meaningful prepayment premium as well as a typically a one year non-call period. In our standard loans, anyone who refinances us one year, non-call period would typically have to pay us a make whole premium as well.
And then the lastly on the Kemper JV, you took that down you've talked a little bit about the performance and views longer term there. But do you see recovery valuing your equity as spread income potentially returns?
Yes. We've taken steps to optimize our Kemper JV and adding $91 million during the quarter. We took over the vehicle was under invested. That’s why you saw the equity being taken down. But overtime as we ramp the vehicle and optimize that we expect that it will be covered.
The next question comes from Christopher Testa of National Securities.
So just curious, you guys noted that you have 104 million of underperforming non-core and only 67 million of that are non- accrual. So, the delta between those two, I’m just curious, if how many portfolio companies comprised of that difference? And is that confined to a certain problematic sector in the inherited portfolio like healthcare? or is it just more spread out?
It’s not confined to a specific sector. It is more broad-based on company specific. So it’s less about the specific industry of these investments and much more about the specific -- company specific issues there.
And, Edgar, how many companies comprised of difference that are not yet on mom-accrual?
There are -- there’s one company right now, that’s on non-accrual.
No, no. I mean between -- so you have 104 million underperforming and then they’re 67 million on on-accrual. So, the difference between the 104 and 67 like how many companies are within that underperforming but not yet on non-accrual status bucket?
It’s one company?
That still one. Okay. And I know, you guys had previously talked about Fifth Street’s healthcare book had a lot of reimbursement risk and other issues. Just wondering, if there’s been any noticeable difference in the trend for any of these whether positive or negative over the last quarter?
I would say it’s a mixture. When we -- as a general matter, the legacy Fifth Street portfolio, many of those companies we’ve already exited. Those that were in healthcare did have some challenges with reimbursement risks. We did manage to move a number of those positions out of a portfolio already. As we look at this bucket of underperforming companies in healthcare for example. I would say generally the healthcare companies have had pretty balanced performance with at least one of them experience relatively positive trends more recently.
And looking at the non-accruals, I know that Garrison Film resolution was added and that’s also a position in the JV previously Ameritox and Metamorph more were on the balance sheet and in the JV. Is your policy going forward to have the Kemper JV have completely, totally different investment mandates? So should we expect there to not be co-investment between that and the on balance sheet portfolio? Or will you opportunistically put them in both buckets as well?
I would expect that overtime, the Kemper JV portfolio will start to look slightly different than the overall portfolio overtime, but there will continue to be some level of overlap between the JV and the main BDC.
[Operator instructions] Our next question will come from Ryan Lynch of KBW.
One question on the leverage, you mentioned you guys read about 0.73x debt-to-equity today, But if I look at your balance sheet, you guys had about a $167 million payables on several transactions on the balance sheet, which I am assuming or have close post quarter and if you add those to your current leverage, as you guys at be at 0.92x debt-to-equity, so that’s outside of your normal kind of targeted debt-to-equity range. So can you just talk about where you guys expecting some big prepayments, repayments early in the third quarter to offset those? Or did you guys sell some non-core DSL loans or just kind how that’s working?
Good morning and thanks for the question. So one item to keep in mind is that we did have cash on the balance sheet as well, as there was just timing around proceeds coming in and capital going out, and so we would imagine that you’d see our leverage within the range, target range that we’ve been -- we have mentioned in the past. Again it’s just really a timing items here, as we don’t anticipate moving materially out of target ranges in the quarter.
Since the beginning of the third quarter, we have had some monetization events occur, but we anticipate that will continue to occur throughout the quarter and we have been deploying capital as well during the quarter. So, you can imagine that just basically for your modeling purposes expect that leverage will stay in line with our historical levels.
Okay, that’s good to know. And then -- and you guys don’t have done a really great job of monetizing a lot of non-core assets even in the most recent quarter you guys had substantial decrease. You still have about $350 million of non-core of investments. I would think that monetizing, I guess early on in the monetization process of reducing non-core investment. I think I would assume it would like be easier to monetize some of those investments maybe pick of some of the lower hanging fruit as we start to get down to the bottom hand of these non-core investments. Should we expect a lengthy period from now to reducing those $350 million of remaining of investments?
I wouldn’t necessarily characterize it that way. I think people looked historically at assets that we have monetized a number of those assets were challenge as well. So, I don’t know if it’s really a fair characterization to assume that the balance of these investments are the most challenged investments, that we originally identified in the non-core buckets. But rather it’s been relatively spread out.
As we go forward, if we were to breakdown the non-core bucket, I think one way to look at it is about half of those investments are in assets that are either liquid investments where we do have an active bid in the marketplace where we can sell those assets, and I’ll come back to the reasons why we haven’t necessarily move those right away.
Two, they’re -- that also includes assets that we are actively selling, right now, where we may have restructured or own the Company today, and we are actively marketing and selling those companies.
Or three, companies where we are actively trying to sell the dead investments; and lastly, investments where we have received notice that the Company are and the borrowers to refinance our loans, there is always uncertainty in those later three buckets around timing. And when that can occur, but I would say that for about half of that bucket or little over half of that bucket, there is active activities going on to further reduce our non-core exposure.
There is also a portion of investments in the portfolio about a quarter of that non-core bucket that are equity investments those include equity co-invest as well as LP interest, we've monetized these significant portion of those LP interests over the last quarter. We do have the ability to monetize the balance of those LP interest, but we do think there is additional upside potentially in those LP interest we've made a determination that we think it's advantageous for shareholders, if we hold on those investments and see if we can harvest some of that additional upside.
There are also co-investments in the portfolio a number of those that are being monetized overtime as the private equity firms that own these specific companies look to monetize these assets. So, we would expect over the coming quarters that will see the equity portfolio be reduced in size purely because the borrowers look to monetize those assets.
So, we anticipate there is going to be a fair amount of additional monetizations coming in the quarter. I should have mentioned just on the liquid portion of the portfolio, there is a portion of that over 50% that are more liquid loans that we could monetize. Part of that is just function of timing of those companies tend to be companies that are performing well but may not necessarily reflect the type of companies we would prefer to lend to, but again those companies are performing well and it should managing the timing of monetization.
One thing to note this past quarter was that over two thirds of our monetizations came in the first half of the quarter. But our new investments well over half them were in the second half of the quarter. So you start to end up with the little bit of a timing mismatch at points in time. And while we prefer for the timing to be more even throughout the quarter, we thought it was more prudent to take advantage of what we saw very robust marketplace and monetize disproportionately larger amount of the non-core investments sooner rather than later. But as we move forward, we anticipate it maybe a slightly more balanced so the impact will be a little bit less pronounced.
Our next question will come from Fin O'Shea of Wells Fargo. Please go ahead.
Appreciate a lot of color given on the portfolio and outlook today. I'll go to portfolio name. Think-5, I believe was a new non-accrual and next kind have been quite a down a bit under your tenure as manager. Can you kind of give us a feel of the -- what's going on underneath there and understanding that it might have just how we looking at the business their customers I believe our major hotel chains? Is there a customer concentration issue there?
Good morning and thanks for the question. There is a limit to what we can comment on with respect to Think-5 as hopefully you appreciate some of this information is subject to confidentiality arrangements. But what I would say about Thank-5 is, when we first took over the portfolio, we did identify this is one of the non-core underperforming assets in the portfolio. And so we are early on identified that there was an elevated risk associated with this company of defaults and therefore categorized that the way we did.
The Company itself has experienced some level of softness, previously had more significant customer concentration. I would say that the Company has done a good job of trying to enhance its overall mix of customers, but it has had some softness over the last few quarters here. Hence, why you’re seeing it reflected and how we’ve marked the position it’s really a function of, it’s not significant disjointedness in the cash flow I would say. I guess I would characterize it more as there’s just generally been softness in that particular situation.
Sure. That helps. And then on -- it looks like this quarter you were able to manage a lot of exits on the LP private equity stakes all of course originated under previous management. Can you give us some color on the marks you were able to exit those at, assuming that you found secondary buyers or sold them to an agent of sorts?
It’s Matt. Thanks for the question. We sold them pretty much, right at our marks. So, it’s a very, very robust market out there for these equities, these positions. So, we’re really pleased with the execution there. And Edgar said, we kept some of the stakes and either some other co- investments we kept. Primarily because we like them and so some of these investments even though there non-core Edgar said, if we see more value in holding them and selling them that’s what we’ll do. So expect to see that over the next few quarters.
Okay. That’s all for me. Thanks very much.
And I do think as relates to kind of the non-core performing. Just I think we, if you look at our deck we posted on Page 7 and 8, I think there’s some good detail that people find helpful in terms of how we provided more information on those to portfolio.
The next question will come from Terry Ma of Barclays.
So it sounds like from your prepared remarks that you want remain the expense is going forward and you’re just willing to accept the lower yield. So maybe can you just talk broadly about what needs to change for you to be more constructive on the environment and take more risk? Or is this low return environment, just new norm going forward?
I wouldn’t say that lower return environment is the new long-term norm. I think if you look at the history of the credit markets, the ebb and flow and spreads widen and contract. I think the contracting spread environment is just a reflection of increasing competitiveness in the middle market -- the market for middle market loans. We’ve seen a tremendous amount of capital flow into the direct lending space over the last couple of years, and that’s led to aggressiveness among direct lending firms for new assets, and that is led to some spread compression.
But also we’ve had a very strong economic environment, and that’s also reflected in credit spreads, which suggest that there is just less risk overall in the marketplace today. Do I think that will correct? It will correct at some point in time. I am not a forecaster of economic activity, but history suggests that we’ll see some level of rebalancing in the credit market at some point in the future.
For us, what we’re doing right now is given the breadth of our platform, we’re able to not only look at the private equity or sponsor-backed/owned companies but we’re also able to go and source to look at opportunities in the non-sponsor backed portion in the marketplace, and we’re spending a pretty significant amount of activity in that area of the market because we are just finding less efficiency there and some really interesting opportunities.
That doesn’t mean that we are avoiding the private equity marketplace, it just means that we’re exercising a significant amount of discipline there to make sure that we don’t participate in the overall plus portions of that part of the marketplace, as it is today, since taking over management of this BDC, we have increased the non-sponsor portion of the portfolio to approximately 20%, that’s up of about 7% when we initially took over.
Next, we have a question from Chris York of JMP Securities.
Hey guys just one follow-up. So, as I look line by line at non-accruals or even non-core investments. Is there one investment that you think has the best recovery value in event, let’s say, a couple bulk case events occurred?
We’re generally not in the practice of commenting on individual investments. But I would say that general statement, the -- especially in the non-core underperforming portion of the portfolio. I think we have commented in the past and that this portion of the portfolio is marked at an average fair market value of $1.38 and well business conditions -- specific business conditions in the market environment could change and lead to some downside there. We think there is the possibility of also generating some significant an upside there just given where those positions are currently carried today.
We have no further questions Mr. Mosticchio.
Thank you again for joining us for our third fiscal quarter 2018 earnings conference call. A replay of this call will be available for 30 days on OCSLs website in the Investor section or by dialing 877-344-7529 for U.S. callers, or 1-412-317-0088 for non-U.S. callers, with a replay access code 101-219-85, beginning approximately one hour after this broadcast.
The conference is now concluded. Thank you for attending today’s presentation. You may now disconnect.