Q3 2022 Oaktree Specialty Lending Corp Earnings Call

August 4, 2022

Welcome and thank you for joining Oaktree specialty lending Corporation third fiscal quarter 2022 conference call.

Today's conference call is being recorded at this time all participants are in a listen only mode, but will be prompted for a question and answer session. Following the prepared remarks.

Now I would like to introduce Michael must reach your head of Investor Relations, who will host today's conference call.

Mr. Mr. Gilles you may begin.

Thank you operator, and welcome to Oaktree specialty lending Corporation's third fiscal quarter conference call our earnings release, which we issued this morning and the accompanying slide presentation can be accessed on the investors section of our website at Oaktree specialty lending dot com.

Our speakers today are Armen <unk>.

Chief Executive Officer, and Chief Investment Officer, Matt <unk>, President and Chris Mccown, Chief Financial Officer, and Treasurer also joining us on the call today for the question and answer session isn't that Stuart our Chief operating officer.

Before we begin I want to remind you that comments on today's call include forward looking statements, reflecting our current views with respect to among other things our future operating results and financial performance.

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 in further detail, we undertake no duty to update or revise any forward looking statements.

Also like to remind you that nothing on 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 the company encourages investors the media and others to review the information that it shares on its web.

Right.

With that I would now like to turn the call over to Matt.

Thank you Mike and welcome everyone. We appreciate your interest in and support of Ocs L. Our fiscal third quarter results reflect our ability to identify and invest in attractive opportunities across public and private markets amid the recent volatility maintained excellent credit quality.

And drive strong earnings on behalf of our shareholders.

Adjusted net investment income per share was <unk> 17 cents for the quarter down slightly from the 18 for the prior quarter and on par with our fiscal first quarter, demonstrating the strength of our earnings profile.

As a result of our ongoing solid portfolio performance and a consistent earnings our board increased our quarterly dividend by 3% to <unk> 17 per share. This marked our ninth consecutive quarterly dividend increase our dividend is now up nearly 80% from its pre COVID-19 level.

We reported NAV per share of $6.89 down 5% from the prior quarter. However, the decrease was driven by broader equity and fixed income market volatility, leading a leading to widening credit spreads and the associated mark to market write down.

Now turning to the portfolio, we originated $132 million of new investment commitments in the second quarter of these 76% were first lien loans up from 70%, 72% in prior quarter in the prior quarter and approximately half of these were in private transactions and the other half or secondary market.

The weighted average yield on new debt investments in the quarter was attractive at nine 2% up from eight 7% in the prior quarter.

While we are highly selective and focused on new deals with favorable pricing and structures. We expect to continue identify interesting investment opportunity across private and public market given the breadth of the Oaktree platform and our team's focus on finding the best relative value in all market conditions.

We received $130 million from prepayment Paydowns and exits in the third quarter.

Our noncore portfolio further declined in the quarter following a $70 million pay down in one of our debt position.

This book represented $77 million at the close of the quarter or about 3% of the portfolio at fair value.

Credit quality remains excellent supported by our disciplined underwriting we again had no investments on non accrual at June 30, Importantly, we continued to be rated investment grade by both Moody's and Fitch and we maintained borrowing flexibility and ample liquidity to meet funding needs. We closed the period with $455 million.

Undrawn capacity under our credit facilities and $34 million of cash with no near term maturities and significant amount of dry powder, we believe our current capital structure positions us.

Well to to invest and do they ever changing market.

Weighted average interest rate on debt outstanding was three 2% in the June quarter up from two 5% the prior quarter with that I'll turn the call over to arm.

Thanks, Matt and good day, everyone I'll begin with comments on the market environment and continue with highlights from our fiscal third quarter our.

Our consistently solid credit quality underpinned by our commitment to prudent underwriting and highly selective investing again provided an excellent foundation for our performance in the quarter.

We believe this will serve us, particularly well in an increasingly volatile market and broader economy that is vulnerable amid an elevated inflation and rising interest rates.

<unk> based inflation in the U S reached a 41 year high in June amplified by the war in Ukraine, and Western government sanctions against Russia. The energy complex in opposition to the conflict. This injected more uncertainty into our global oil and gas market. There was already grappling with supply demand imbalances.

For the U S. This is evident in lofty gasoline and industrial power prices on top of high food real estate and other costs. Additionally.

Additionally, China continues to struggle with Corona virus outbreaks.

The government there has repeatedly and post business and travel restrictions that threatened to compound the supply chain issues that initially ignited inflationary pressures.

Central banks, including the U S. Federal reserve have responded with tightened monetary policy, notably including aggressive interest rate hikes.

Historically in periods of rapid rate increases U S. Consumers are pulled back on spending and tip the economy into recession.

Markets had widely anticipated rate increases, but the pace at which the fed has moved and the pace. It signaled it will continue to move.

<unk> prior expectations and spurred volatility across equity markets in the second calendar quarter.

Spreads widened across public credit asset classes.

At Oaktree, we don't make investment decisions based on economic forecast, but we believe it is important to be aware of evolving macro condition and their impacts on markets and industry.

While there is risk of recession underscores the importance of our conservative approach to investing it also creates opportunities for us.

<unk> roots are in are in investing across market cycles, and we have demonstrated over many years, our ability to identify and successfully invest in these types of volatile markets.

During the quarter this market volatility created a number of attractive opportunities in the public debt markets, where we saw many high quality loans trade lower and being offered at discounts to par value. We acted on several of these situations picking up what we believe to be investments that are worth par.

At meaningful discounts some in the range of 15% to 20% with these investments, which we underwrite assuming we will hold to maturity, we expect to realize an attractive total return as they eventually trade back to par value overtime.

We also continue to capitalize on Oaktree scale and resources to invest across a diverse array of private credit loans that we believe provide downside risk protection and relative value for our shareholders. In some cases, we are finding new deals in areas of the market that are less competitive by lending to non sponsor owned businesses investing in this area require specialization and robust sourcing capabilities.

Few managers possess and there's less crowded segment of the market, we believe that our scale and capacity to make complex loans is a competitive advantage and can lead to superior investment outcomes.

We also continue to assess the sponsor lending market partnering with proven private equity firms, we know well that have expertise in certain industries.

Ever rising interest rates and declining valuation multiples have decreased pay back deal flow over the last several months. Moreover, an abundance of capital has been raised to support M&A transactions. So we remain particularly cautious when you're evaluating these investments given the potential for a supply demand imbalance amid the slower deal activity as <unk>.

You've heard me say for some time now we also continue to find attractive loans with a growing and increasingly prominent life sciences sector.

Public market valuations of life Sciences companies have sold off significantly over the past year. So companies may seek non dilutive financing via private lenders such as Oak tree. In addition, we anticipate that significant lending opportunities will continue to develop driven by technological advancements and sizable R&D requirements.

In summary, we are very active yet conscience of economic headwinds and focused only on deals that meet our high risk reward standards.

We believe our borrowers are well positioned for a rising interest rate environment and that higher rates will not result in materially weaker credit performance. The portfolio's weighted average interest coverage was strong at approximately three times as of June 30.

We also feel good about the underlying leverage profile at our portfolio of companies, which was generally in line with the prior quarter at approximately four nine times.

Moving on to investment activity.

$132 million of new investment commitments were spread across 12, new and 16 existing portfolio of companies in the third quarter approximately half of our originations went into private transactions and the other half into secondary purchases in the public debt market as I highlighted earlier.

Let's take a look at a couple of emblematic examples of private opportunities we found in the quarter.

Establishment labs, a commercial stage medical device company and aesthetics company.

Focus on body shaping implants.

The company saw a $225 million commitment to refinance existing debt and fund the construction of a new manufacturing facility among other growth initiatives Oaktree financing deal over four tranches with $150 million in the first tranche that carried a 9% interest rate.

<unk> was allocated $15 million.

The Grove resort in Waterpark, and 878 unit condo resort complex in Orlando, Florida, Oaktree served as a sole lender and provided a $65 million financing package to support the purchase of the property by a pair of financial sponsors. This newly built upscale resort includes a seven acre water park swimming pools of wholesale.

This Bob and three owned restaurants, as well as daily transportation to Disney World.

With CSL was allocated $19 million of this transaction that was attractively priced at a rate of sofa plus 800.

These are each compelling investments priced attractively with favorable terms that provide meaningful downside protection.

Our origination pipeline remains healthy across a wide range of opportunities in both the private and public markets positioning us well for the remainder of 2022 now I will turn the call over to Chris to discuss our financial results in more detail.

Thank you Armen Ocs.

Both CSL delivered another quarter of solid financial performance.

The strong momentum from the second fiscal quarter of 2022.

For the third quarter, we reported adjusted net investment income of $31 4 million or <unk> 17 per share down slightly from $32 $3 million or <unk> 18 per share in the second quarter.

The decrease was primarily the result of higher interest expense related to the impact of rising LIBOR on our floating rate liabilities as well as lower OID acceleration.

Partially offsetting this was higher adjusted total investment income and lower management and part one incentive fees.

Net expenses for the third quarter totaled $22 $8 million down.

Down $1 4 million sequentially. The decrease was mainly due to lower incentive fees driven by a decrease in accrued capital gains incentive fees, resulting from the unrealized losses during the quarter and slightly lower management fees due to the decline in the fair value of the portfolio. This was partially offset by $2 million or higher.

<unk> expense.

Turning to our credit quality, which continues to be excellent as Matt noted, we had no investments on non accrual at quarter end.

With respect to interest rate sensitivity, both DSL remains well situated to benefit from a rising rate environment as of June 30, 88% of our debt portfolio at fair value was in floating rate investments. We anticipate that further increases in short term interest rates will have a positive impact on earnings importantly, we have not yet experienced.

The full quarter benefit from higher interest rates, because most of our investment rates reset on June 30, while our floating rate liabilities reset during the June quarter.

Base rates as of June 30th where in effect for the entire quarter, we estimate that our adjusted net investment income per share would have been about a penny higher resulting in adjusted NII of about <unk> 18 per share.

In addition, if rates were to increase by an additional 100 basis points from June 30th.

Annual adjusted net investment income could benefit by approximately <unk> <unk> per share.

Now moving to the balance sheet.

<unk> net leverage ratio at quarter end increased moderately from the March quarter to 1.08 times in response to changing market conditions, we are increasing our leverage target higher to a range of 0.9 times to 125 times debt to equity.

We believe this range is appropriate and provides us with increased capacity to deploy capital given the current market backdrop and the expanded set of investment opportunities that we're seeing.

As of June 30, total debt outstanding was $1 4 billion and had a weighted average interest rate of three 2% up from two 5% at March 31, due to rising LIBOR.

Unsecured debt represented 47% of total debt at quarter end consistent with prior quarter.

At quarter end, we had ample liquidity to meet our funding needs with total dry powder of approximately $489 million, including $34 million of cash and $455 million of undrawn capacity on our credit facilities.

Unfunded commitments, excluding unfunded credits to the joint ventures were $182 million with approximately $127 billion of this amount eligible to be drawn immediately as the remaining amount is subject to certain milestones that must be met by portfolio companies.

Shifting to our joint ventures at quarter end, the Kemper JV at $365 million of assets invested in senior secured loans to 56 companies down from $390 million last quarter, driven by spread widening widening across the portfolio.

The JV generated $1 $9 million of cash interest income for Ocs fell in the quarter and we also received an $875000 dividend up from 700000 in the prior quarter as a result of the portfolios continued strong performance.

Leverage at the JV was one six times at quarter end up slightly from the prior quarter.

The Glick JV had $141 million of assets as of June 30 down slightly from $150 million in the prior quarter also due to spread widening these.

These consisted of senior secured loans to 43 companies leverage at the JV was one four times at quarter end, we received $1 $3 million of principal and interest payments on Ocs, all subordinated note and the glick JV during the quarter.

In summary, we continue to be very pleased with our financial results and believe our diverse portfolio and flexible balance sheet positions us well for the current environment now I will turn the call back to Matt.

Thank you, Chris our strong financial results for the quarter enabled us to generate an annualized return on adjusted net investment income of nine 4%. We have generated an average ROE of approximately nine 5% over the last six quarters, and we believe <unk> remains well positioned to increase.

ROE going forward.

First we believe ocs out is well positioned for a rising rate environment as Chris noted earlier with the majority of our investment portfolio in floating rate assets. We expect that further increases in base rates will positively impact our net interest margin <unk>.

Additionally, with our increased leverage target range, we had the opportunity to continue to play more leverage at the portfolio level. However, we will only grow the portfolio as we find opportunities that are consistent with our investment approach that we believe offer an attractive risk reward.

And as we've discussed before we continue to focus on positioning the portfolio for an improved yield by rotating out of lower yielding investments and into higher yielding loans.

Our new investments continue to come on the books at attractive yields which means there is more upside in yield on that portion of the portfolio that we expect to realize over time.

Finally, another ongoing opportunity across the board are re target is to further optimize our joint ventures. We can accomplish this by selectively rotating out of lower yielding investments into higher yielding ones as well as increasing leverage at the JV. We've made good progress on this to date at both vehicles are generating ROE to ocs out of over 10.

Percent.

That said, we are seeing more attractive investment opportunities for the JV in this environment, particularly given their focus on more liquid broadly syndicated loans and anticipate that we will continue to rotate and grow these portfolios over time.

In conclusion, we are very pleased with our strong third quarter financial results against the volatile market backdrop, our portfolio is healthy and we are well positioned to capitalize on this increasingly attractive investment environment with our expanded leverage target and ample dry powder. Thank you for joining us on today's call and for your continued interest in <unk>.

That we're happy to take your questions operator, please open the line.

Thank you.

We will now begin the question and answer session to ask a question you May Press Star then one on your Touchtone phone.

We're using a speaker phone please pick up your handset before pressing the keys.

Anytime Youre question has been addressed and you would like to withdraw your question. Please press Star then two at this time, we will pause momentarily to assemble our roster.

Our first question today comes from Kevin Defaults of J P. M Securities. Please go ahead.

Hi, Good morning, and thank you for taking my questions I would like to start with a high level question for you Armen.

We appreciate your insight on what Youre seeing in the market both on the sponsor side in the non sponsor side, where you guys like to play.

You could just give a high level overview of the opportunities you're currently seeing as well as any changes <unk> seen NGL pricing relative to the last few quarters.

Sure. Thanks for the question.

So a few a few observations.

The first is that for the first half of 2022 on the sponsor side there wasn't really a change in terms either legal or pricing terms.

In deal flow that we saw in comparison to 2021 or 2019.

Obviously, I'm, excluding 2020 due to the COVID-19 related impacts in that year, but.

We really didn't see wider spreads we didn't see tighter legal terms.

And I think it was because of a variety of factors one.

Was.

A lot of capital that's been raised in direct lending over the last few years, it's been sort of a record year. After a record year of fundraising over the last two or three years and two there was a decline in deal flow and.

In M&A volume LBO volume.

This year.

As you saw equity markets.

Having some volatile.

Volatile performance and so a lot of potential sellers when they saw the evaluation multiples decline. They just became less interested in selling their businesses and the uncertainty.

Around exit multiples for private equity firms also created another reason why some private equity firms decided to kind of tap the brakes, a little bit. So we saw in the first half of 2022, a condition, where there was too much capital chasing too few deals on the direct lending side and that's why we were quite.

Concerned about.

The quality of the deal flow that we were generally seeing inspire.

And sponsor back lending now we took our.

Swaps as well and we found some decent situations to invest into.

But by and large we werent happy with the risk adjusted returns and sponsor oriented lending for most of 2022.

On the non sponsored side, it's very hard to.

Deduce any sort of meaningful high level.

Changes in pricing and terms in that area because all of those situations are so bespoke and unique.

One of the next the other reason why it's so hard is because those loans tend to be just higher yielding anyway under all market conditions and so it's very hard for me to say that on the non sponsored side, we did or didn't see.

Widening in in pricing, however, what I did see or we are seeing is that on the <unk>.

Non sponsored side.

Because that part of the market is so inefficient as it is.

We found that.

US generally responding to potential financing opportunities with quantum of debt that was lower than the ask was met with <unk>.

Some level of engagement, which is which is good. So generally speaking we were.

Exercising more conservatism.

<unk>.

Then than what we've historically, what I've just given the general economic backdrop, and we were not told that those were nonstarters. So we do have a variety of different non sponsored situations that we funded this year, we do have a variety of non sponsor situations in our pipeline and I would generally say there.

They feel more conservative conservatively structured in terms of lower debt quantum in terms of tighter covenants.

But I wouldn't say the pricing necessarily has widened in any material respect because those loans were already in the 9% to 14% range, maybe they are skewing, a little bit higher than the average and the historic average, but I wouldn't say materially so.

But we are.

Pleased with.

The conservative kind of structuring that we were able to exercise on the non sponsored side.

But with all that said, it's not like deal flow is.

Very very strong on either of the sponsor organized sponsored side in direct lending at this time.

We do think that there will be very significant opportunities going forward in direct lending for more appropriately structured and priced loans both on the sponsor and non sponsor side as we just hear about some of our peers.

Stepping back from the market that they were.

Very supportive of in the first half of 2022. So we do think that pricing will normalize both on the sponsor side and the non sponsored side and we think there'll be more deal flow going forward, but.

I wouldn't say that we have a tremendous amount of.

Data points against which we can deduce a.

A statistically significant.

Conclusion.

Okay. That's all really helpful. And then just to touch on expectations around prepayment activity just curious what visibility you have on the cadence of prepayments.

Well I mean, I'll keep it very big picture.

So on the.

Sponsor investing generally.

I would expect prepayments to slow.

Mainly because I would expect spreads to widen on refinancings.

And second Gen.

Generally speaking these companies were levered. According to adjusted EBITDA over the last two or three or four years.

And with what's happened in the economy from a from a.

Inflation perspective, both labor cost inflation and commodity cost inflation.

A lot of these companies are not really able to grow into their capital structures and therefore, historically a lot of the prepayments.

Activity that we saw was because these businesses were able to grow into their capital structures, we're able to do dividend recaps at even tighter spread than the original debt and that's just no longer the case. So I would generally say that sponsor oriented direct loans and frankly spots oriented broadly syndicated loans are highly unlikely to prepay.

At the same speed that they have done historically on the non sponsored side again every situation is so bespoke and catalyst driven.

We do expect to see some level of prepayments associated with the idiosyncratic.

Credit.

<unk> of each company.

And so I wouldn't say that there is necessarily a trend there because the.

The trend is not a macro trend that is more of a company specific.

Matter.

But.

I would generally say that in.

What we're seeing on the non sponsored side and in our involvement.

Has shown that the companies we have invested in are generally performing quite well.

And any sort of.

<unk>.

Anticipation around prepayments that we would have expected in a non sponsored deal activity.

Around realization of certain catalysts, where milestones those are kind of happening.

As one would expect and so we can't predict necessarily how those prepayments will go but the company performance has been consistent with the historic.

Performance and according to expectations and so I would expect some level of prepayments on that side.

Okay I'll leave it there and I appreciate your time this morning.

Thank you.

The next question comes from Kyle Joseph with Jefferies. Please go ahead.

Hey, good morning, Thanks for thanks for taking my questions.

Just wanted to get a sense for you know obviously no non accruals.

Good.

Just how you expect industry credit to perform over the next call it 18 months.

They are faced with higher debt surface debt servicing costs and do you anticipate you know the middle market credit kind of turning for the worse and do you see that as a potential opportunity for you guys.

Yeah.

Thanks Carl.

It's really hard to make a big prediction, but.

<unk>.

I would say I made a prior comment about companies being levered. According to adjusted EBITDA in the assumption that they will grow into their capital structures.

Inc.

That's going to weigh on performance.

Levered free cash flow.

Performance for a lot of these borrowers.

And I think that's going to continue for quite some.

Got some time.

Clearly wants to put some cold water on the economy and I think there'll be successful at doing that.

So between that and just generally speaking higher borrowing costs by the way as of June 30.

Borrowers that had floating rate.

Bank debt subject to a floor.

Our now LIBOR is now in a place where we are above almost all of those if not all of them and so this is truly a floating rate asset class on the floating rate liability for these borrowers. So I think it is going to get painful broadly speaking for a lot of these a.

A lot of these private equity owned businesses, especially where leverage was maximize.

And.

The industries that have the.

Tightest margins, either gross margins or EBITDA margins are going to be the ones that feel it the most.

Because when you do have such type margin, that's indicative of you're not being a leader in your particular sector, we're not being a value additive part of the supply chain of whatever eventual good or service that is being sold.

And so we're very cautious on those types of businesses, we generally have been avoiding those types of businesses, but.

I think that's where the pain will be felt so if you want to look at industries to try to try to triangulate where industries will have the most pain I think thats one way to look at it as what industry generally speaking have had low margins or what what middle market companies generally speaking have low margins that would define low margin that sort of mid single mid to maybe even upper single.

The next question comes from Ryan Lynch with <unk>. Please go ahead.

Hey, good morning.

First question I had was you guys, obviously changed your leverage range ticket higher bar.

The bottom of that range really didn't move too much but then the upper end of the range.

A bit I'm just curious how are you thinking about that in today's environment Thats. A wider range is is that something that you intend to depending on the market opportunity set that you are seeing today in the marketplace of operating close to the upper end of that range or is that something where you guys are comfortable.

Sort of where you at are at today, and you're kind of giving yourself. Some more cushion in case there is further disruption.

In the credit markets going forward.

Thanks for the question, it's really the latter.

It is we don't really have a plan to generally speaking the operating in the upper end of that range, but we do want to maintain the flexibility.

Round expectations with our shareholders and with the rating agencies that if there is a a market event or an economic event that creates the opportunity for us to realize.

Or for us too.

Originating well structured and well priced loans, especially something like a rescue lending opportunities that we may see over the next 12 or 18 months, we'd like the ability to be able to do that and not surprise anybody. So that's really the cause for the widening of that range, but it's not the expectation that we will generally in <unk>.

<unk> be operating at the upper end.

Understood.

I had a question on the you talked a lot about you know the primary markets in both the sponsor and non sponsor I had a question in the secondary markets. You guys are obviously very active in that marketplace. I think you guys put up a slide slide number seven I think is a very helpful illustration of your guys' willingness to step in and kind of.

The dislocation in the liquid markets I'm curious I think loan prices are generally kind of trended a little bit higher.

In the third quarter calendar third quarter.

Are you still seeing that same sort of opportunity set that you saw in the second quarter and in the secondary liquid markets or not.

Okay.

Yes.

I would say generally speaking.

The market has moved higher both in high yield bond ban in senior loans high yield is up 6% in July senior loans are up one 8% in July .

And that's.

Obviously, a move in the right direction I guess, but.

There isn't a lot of liquidity in the market.

Either on the buy side or the sulfide. So it doesn't take much to move prices either up or down.

So one month a trend does not make.

So I'm I'm not sort of closing the book and calling it good.

But I would say generally speaking the prices have moved in a direction where.

We are not really investing.

We're rapidly we think that there is sort of more volatility ahead in the economy and probably in the markets and there is sort of a temporary fund flows.

Factor here that is driving prices higher or has driven prices higher in July .

But I would expect further volatility so we continue to be prudent we're not going to chase the market higher.

And so we've been we were fairly active in the in the second quarter and we will be active again, but.

But.

Yes.

We don't think that the.

Secondary buying opportunity is necessarily over at this point.

And we're going to just continue to watch it.

To add one when the time is right.

Okay.

<unk>.

Thanks for taking my questions I appreciate the time today.

Okay. Thank you.

Again, if you have a question. Please press Star then one.

Our next question comes from Melissa Wedel of J P. Morgan. Please go ahead.

Good morning, Thanks for taking my questions today.

Actually answered a few of them already but I was hoping we could touch on timing of activity in the June quarter.

Wondering if activity was particularly skewed towards the backend of the quarter.

And maybe not fully maybe the topline not fully reflecting.

On the earning power of that the new investment.

Is there anything like that going on into the June quarter.

Yes, I'll hand that over to Chris.

Maybe Chris or Matt Stuart.

Either of you have a view on that timing I know I know it did it did have an impact but that could give you a more refined response.

Yes, thanks for the question.

I would say that it was.

Not so much of a tiny matter so much as it was.

Matter related to.

Right right.

We started to see the impact of the rising reference rates during the quarter.

A good portion of the portfolio did not reset until June 30th So as I mentioned in my prepared remarks, we did try to provide some color around this at.

June 30 rates had been in effect as of March 31.

Our adjusted NII, all else equal would have been up about a penny a share for the quarter. So that was.

More of a driver versus the timing of deployment.

Okay. That's helpful. Thank you that's it for me.

We have no further questions Mr <unk>.

Great. Thanks, Sanjay and thank you all for joining us on today's earnings conference call. A replay of this call will be available for 30 days on <unk> website in the investors section or by dialing 870, 734 475 to nine for U S callers or one four.

123170088 for non U S callers with the replay access code 7421084.

Beginning approximately one hour after this broadcast.

The conference has now concluded. Thank you for attending today's presentation you may now disconnect.

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Welcome and thank you for joining Oaktree specialty lending Corporation third fiscal quarter 2022 conference call.

Today's conference call is being recorded at this time all participants are in a listen only mode that will be prompted for a question and answer session. Following the prepared remarks.

Now I would like to introduce Michael <unk> head of Investor Relations, who will host today's conference call.

Mr. Mr. <unk> you may begin.

Our speakers today are Armen, <unk>, Chief Executive Officer, and Chief Investment Officer, Matt <unk>, President and Chris Macau, Chief Financial Officer and Treasurer.

Also joining us on the call today for the question and answer session is Matt Stuart our Chief operating officer.

I'd like to remind you that nothing on 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 the company encourages investors the media and others to review the information that it shares on its web.

Right.

With that I would now like to turn the call over to Matt.

Thank you, Mike and welcome everyone.

We appreciate your interest in and support of Ocs L. Our fiscal third quarter results reflect our ability to identify and invest in attractive opportunities across public and private market amid the recent volatility maintained excellent credit quality and drive strong earnings on behalf of our shareholders.

Adjusted net investment income per share was <unk> 17 for the quarter down slightly from the 18 for the prior quarter and on par with our fiscal first quarter, demonstrating the strength of our earnings profile.

We reported NAV per share of $6 89 down 5% from the prior quarter. However, the decrease was driven by broader equity and fixed income market volatility made any leading to widening credit spreads and associated mark to market write down.

Now turning to the portfolio, we originated $132 million of new investment commitments in the second quarter.

Of the 76% were first lien loans up from 70%, 72% in prior quarter in the prior quarter and approximately half of these were in private transactions and the other half or secondary market purchases. The weighted average yield on new debt investments in the quarter was attractive at nine 2% up from.

Eight 7% in the prior quarter.

While we are highly selective and focused on new deals with favorable prices and structures. We expect to continue identify interesting investment opportunity across private and public market given the breadth of the Oaktree platform and our team's focus on finding the best relative value in all market conditions.

We received $130 million from prepayment Paydown and exited in the third quarter, our noncore portfolio further declined in the quarter following a $70 million pay down in one of our debt position.

This book represented $77 million at the close of the quarter or about 3% of the portfolio at fair value.

Undrawn capacity under our credit facility and $34 million of cash with no near term maturities and significant amount of dry powder, we believe our current capital structure positions us.

Well to invest in today's ever changing market.

Weighted average interest rate on debt outstanding was three 2% in the June quarter up from two 5% in the prior quarter with that I'll turn the call over to arm.

Thanks, Matt and good day, everyone I will begin with comments on the market environment and continue with highlights from our fiscal third quarter our.

Our consistently solid credit quality underpinned by our commitment to prudent underwriting and highly selective investing again provided an excellent foundation for our performance in the quarter.

We believe this will serve us, particularly well in an increasingly volatile market and broader economy that is vulnerable amid an elevated inflation and rising interest rates.

For the U S. This is evident in lofty gasoline and industrial power prices on top of high food real estate and other costs. Additionally.

Additionally, China continues to struggle with Corona virus outbreaks.

The government there has repeatedly imposed business and travel restrictions that threatened to compound the supply chain issues that initially ignited inflationary pressures.

Central banks, including the U S. Federal reserve have responded with tightened monetary policy, notably including aggressive interest rate hikes.

Historically in periods of rapid rate increases U S. Consumers are pulled back on spending and tip the economy into recession.

Markets had widely anticipated rate increases, but the pace at which the fed has moved and the pace. It signaled it will continue to move.

<unk> prior expectations and spurred volatility across equity markets in the second calendar quarter.

Spreads widened across public credit asset classes.

At Oaktree, we don't make investment decisions based on economic forecast, but we believe it is important to be aware of evolving macro conditions and their impact on markets and industry.

The risk of recession underscores the importance of our conservative approach to investing it also creates opportunities for us.

<unk> roots are in investing across market cycles, and we have demonstrated over many years, our ability to identify and successfully invest in these types of volatile markets.

Few managers possess in this less crowded segment of the market, we believe that our scale and capacity to make complex loans is a competitive advantage and can lead to superior investment outcomes.

We also continue to assess the sponsor lending market partnering with proven private equity firms, we know well that have expertise in certain industries. However.

However, rising interest rates and declining valuation multiples have decreased pay back deal flow over the last several months. Moreover, an abundance of capital has been raised to support M&A transactions. So we remain particularly cautious when evaluating these investments given the potential for a supply demand imbalance amid the slower deal activity.

As you've heard me say for some time now we also continue to find attractive loan to the growing and increasingly prominent life sciences sector.

In summary, we are very active yet cautious of economic headwinds and focused only on deals that meet our high risk reward standards.

Now, let's turn to the overall portfolio.

At the close of the third quarter, our portfolio was well diversified with $2 6 billion at fair value across 151 companies.

Nearly 87% of the portfolio was invested in senior secured loans with first lien loans representing 70%.

This reflects our emphasis on the top of the capital structure, we are well positioned for further rate increases with 88% of our debt floating rate as.

As Chris will highlight later on we saw a slight benefit of this in the June quarter and expect to see more in the September quarter.

We remain focused on lending to larger more diversified businesses that we believe carry lower risk median portfolio company EBITDA as of June 30 was approximately $128 million up from $118 million in the prior quarter. The increase was primarily driven by our secondary purchases in the public debt market, which are typically in large.

Established companies.

We also feel good about the underlying leverage profile at our portfolio companies, which was generally in line with the prior quarter at approximately four nine times.

Moving on to investment activity or $132 million of new investment commitments were spread across 12, new and 16 existing portfolio of companies in the third quarter approximately half of our originations went into private transactions and the other half into secondary purchases in the public debt market as I highlighted earlier lets take a.

Look at a couple of emblematic examples of the private opportunities we found in the quarter.

Establishment labs, a commercial stage medical device company and aesthetics company.

<unk> focused on body shaping implants.

The company saw a $225 million commitment to refinance existing debt and fund the construction of a new manufacturing facility among other growth initiatives Oaktree finance the deal over four tranches with $150 million in our first tranche that carried a 9% interest rate.

<unk> was allocated $15 million.

The grow of resort in Waterpark, and 878 unit condo resort complex in Orlando, Florida, Oaktree served as a sole lender and provided a $65 million financing package to support the purchase of the property by a pair of financial sponsors. This newly built upscale resort includes a seven acre water park swimming pools of wholesale.

Bob and three owned restaurant as well as daily transportation to Disney World.

<unk> was allocated $19 million of this transaction that was attractively priced at a rate of sofa plus 800.

These are each compelling investments priced attractively with favorable terms that provide meaningful downside protection.

Thank you Aman.

<unk> delivered another quarter of solid financial performance.

The strong momentum from the second fiscal quarter of 2022.

For the third quarter, we reported adjusted net investment income of $31 4 million or.

Or <unk> 17 per share down slightly from $32 $3 million or <unk> 18 per share in the second quarter.

The decrease was primarily the result of higher interest expense related to the impact of rising LIBOR on our floating rate liabilities as well as lower OID acceleration.

Partially offsetting this with higher adjusted total investment income and lower management and part one incentive fees.

Net expenses for the third quarter totaled $22 $8 million down.

First expense.

Turning to our credit quality, which continues to be excellent as Matt noted, we had no investments on non accrual at quarter end.

A full quarter benefit from higher interest rates, because most of our investment rates reset on June 30, while our floating rate liabilities reset during the June quarter.

In addition, if rates were to increase by an additional 100 basis points from June 30, our annual adjusted net investment income could benefit by approximately <unk> <unk> per share.

Now moving to the balance sheet.

We believe this range is appropriate and provides us with increased capacity to deploy capital given the current market backdrop and the expanded set of investment opportunities that we're seeing.

As of June 30, total debt outstanding was $1 4 billion.

Weighted average interest rate of three 2% up from two 5% at March 31, due to rising LIBOR.

Unsecured debt represented 47% of total debt at quarter end consistent with prior quarter.

Unfunded commitments, excluding unfunded credits through the joint ventures were $182 million with approximately 127 billion of interest amount eligible to be drawn immediately as the remaining amount is subject to certain milestones that must be met by portfolio companies.

Leverage at the JV was one six times at quarter end up slightly from the prior quarter.

The Glick JV had $141 million of assets as of June 30 down slightly from $150 million in the prior quarter also due to spread widening these.

Thank you Chris.

Our strong financial results for the quarter enabled us to generate an annualized return on adjusted net investment income of nine 4%. We have generated an average ROE of approximately nine 5% over the last six quarters, and we believe <unk> remains well positioned to increase ROE going forward.

First we believe <unk> is well positioned for rising rate environment as Chris noted earlier with the majority of our investment portfolio in floating rate assets. We expect that further increases in base rates will positively impact our net interest margin.

And as we've discussed before we continue to focus on positioning the portfolio for an improved yield by rotating out of lower yielding investments and into higher yielding loans.

Our new investments continue to come on the books at attractive yield which means there is more upside in yield on that portion of the portfolio that we expect to realize over time.

Finally, another ongoing opportunity for us our target is to further optimize our joint ventures. We can accomplish this by selectively rotating out of lower yielding investments into higher yielding ones as well as increasing leverage at the JV.

We made good progress on this to date at both vehicles are generating ROE to ocs out of over 10% that said, we are seeing more attractive investment opportunities for the JV in this environment, particularly given their focus on more liquid broadly syndicated loans and anticipate that we'll continue to rotate and grow these portfolios over time.

In conclusion, we are very pleased with our strong third quarter financial results against the volatile market backdrop, our portfolio is healthy and we are well positioned to capitalize on this increasingly attractive investment environment with our expanded leverage targeted ample dry powder. Thank you for joining us on today's call and for your continued interest in CSL.

That we're happy to take your questions operator, please open the line.

Thank you.

We will now begin the question and answer session to ask a question you May Press Star then one on your Touchtone phone.

You are using a speakerphone please pick up your handset before pressing the keys.

If at any time. Your question has been addressed and you would like to withdraw. Your question. Please press Star then two at this time, we will pause momentarily to assemble our roster.

Our first question today comes from Kevin <unk> of J P. M Securities. Please go ahead.

Hi, Good morning, and thank you for taking my questions I would like to start with a high level question for you Armen.

Appreciate your insight on what Youre seeing in the market both on the sponsor side in the non sponsor side, where you guys like to play if you could just give a high level overview of the opportunities you're currently seeing as well as any changes you've seen NGL pricing relative to the last few quarters.

Yeah.

Sure. Thanks for the question.

So a few a few observations.

The first is that for the first half of 2022 on the sponsor side there wasn't really a change in terms either legal or pricing terms.

In deal flow that we saw in comparison to 2021 or 2019, obviously I'm, excluding 2020 due to the COVID-19 related impacts in that year, but.

We really didn't see wider spreads we didn't the tighter legal terms.

And I think it was because of a variety of factors one.

Was a lot.

A lot of capital has been raised in direct lending over the last few years, it's been sort of a record year. After a record year of fundraising over the last two or three years and two there was a decline in deal flow and.

In M&A volume LBO volume.

This year.

As you saw equity markets.

Having some volatile.

Volatile performance and so a lot of potential sellers when they saw the evaluation multiples decline. They just became less interested in selling their businesses and the uncertainty.

Concerned about.

The quality of the deal flow that we were generally seeing in.

And sponsor bank lending now we took ours.

Swaps as well and we found some decent situations to invest into.

But by and large we werent happy with the risk adjusted returns and sponsor oriented lending for most of 2022.

On the non sponsored side, it's very hard to.

Deduce any sort of meaningful high level.

Changes in pricing and terms in that area because all of those situations are so bespoke and unique.

A widening in in pricing however, what I did see or we are seeing is that on the non sponsored side.

Because that part of the market is so inefficient as it is.

We found that.

US generally responding to potential financing opportunities with quantum of debt that was lower than the ask was met with.

Some level of engagement, which is which is good. So generally speaking we were.

Exercising more conservatism.

They feel more conservative conservatively structured in terms of lower debt quantum in terms of tighter covenants.

But I wouldn't say the pricing necessarily has widened in any material respect because those loans were already in the 9% to 14% range, maybe they're skewing a little bit higher than the average and the historic average, but I wouldn't say materially so.

But we are.

Pleased with.

The conservative kind of structuring that we were able to exercise on the non sponsored side.

But with all that said, it's not like deal flow is.

Very very strong on either the sponsor or the non sponsored side indirect lending at this time.

Stepping back from the market that they were.

Very supportive of in the first half of 2022. So we do think that pricing will normalize both on the sponsor side Amazon sponsored by them and we think there'll be more deal flow going forward, but.

I wouldn't say that we have a tremendous amount of.

Data points against which we can deduce a.

A statistically significant.

Our conclusion.

Okay. That's all really helpful. And then just to touch on expectations around prepayment activity just curious what visibility you have on the cadence of prepayments.

Well I mean, I'll keep it very big picture.

So on the on sponsor investing generally.

I would expect prepayments to slow.

Mainly because I would expect spreads to widen on refinancings.

And second Gen.

Generally speaking these companies were levered. According to adjusted EBITDA over the last two or three or four years.

And with what's happened in the economy from a from a.

Inflation perspective, both labor cost inflation and commodity cost inflation.

A lot of these companies are not really able to grow into their capital structures and therefore, historically a lot of the prepayments.

Activity that we saw was because these businesses were able to grow into their capital structures, we're able to do dividend recaps at even tighter spread than the original debt and that's just no longer the case. So I would generally say that sponsor oriented direct loans and frankly sponsor oriented broadly syndicated loans are highly unlikely to prepay.

At the same speed that they have done historically on the non sponsored side again every situation is so bespoke and catalyst driven.

We do expect to see some level of prepayments associated with the idiosyncratic.

Credit <unk>.

<unk> of each company.

And so I wouldn't say that there is necessarily a trend there because the.

The trend is not a macro trend as it is more of a company specific.

Matter.

But.

I would generally say that in what we're seeing on the non sponsored side and our involvement.

Has shown that the companies we have invested in are generally performing quite well.

And any sort of.

Anticipation around prepayments that we would have expected in a non sponsored deal activity.

Around realization of certain catalysts or milestones.

Or kind of happening.

As one would expect and so we can't predict necessarily how those prepayments will go but the company performance has been consistent with the historic.

Performance and according to expectations and so I would expect some level of prepayments on that side.

Okay I'll leave it there and I appreciate your time this morning.

Thank you.

The next question comes from Kyle Joseph with Jefferies. Please go ahead.

Hey, good morning, Thanks for thanks for taking my questions.

Just wanted to get a sense for obviously no non accruals.

Good.

But just how you expect industry credit to perform over the next call. It 18 months as company, they're faced with higher debt surface debt servicing costs and do you anticipate middle market credit kind of turning for the worse and do you see that as a potential opportunity for you guys.

Yes.

Thanks, Scott, it's really hard to make a big prediction, but.

I would say I made a prior comment about companies being levered. According to adjusted EBITDA in the assumption that they will grow into their capital structures.

I think that's going to weigh on performance, our levered free cash flow.

Performance or a lot of these borrowers.

And I think thats going to continue for quite for quite some time the fed clearly wants to put some cold water on the economy and I think that there will be successful in doing that.

So between that and just generally speaking higher borrowing costs by the way as of June 30.

Most borrowers that had floating rate.

Bank debt subject to a floor or.

Our now LIBOR is now at a place where we are above almost all of those loans if not all of them and so this is truly a floating rate asset class in the floating rate liability for these borrowers. So I think it is going to get painful broadly speaking for a lot of these a.

A lot of these private equity owned businesses, especially where leverage was maximized.

And.

The industries that have the.

Tightest margins, either gross margins or EBITDA margins are going to be the ones that feel it the most.

Because when you do have such type margins as indicative of you're not being a leader in your particular sector, we're not being a value additive part of the supply chain of whatever eventual good or service that would be sold.

And so we're very cautious on those types of businesses, we generally have been avoiding those types of businesses, but.

I think thats, where the pain will be felt so if you want to look at industries to try to try to triangulate where industries will have the most pain I think thats one way to look at it as what industry generally speaking have had low margins or what what middle market companies generally speaking have low margins that would define low margin and that sort of mid single mid to maybe even upper single.

Digit type of EBITDA margins.

Got it very helpful. Thanks for answering my question.

No.

The next question comes from Ryan Lynch with <unk>. Please go ahead.

Hey, good morning.

First question I had was you guys, obviously changed your leverage range ticket higher bar.

The bottom of that range really didn't move too much but then the upper end of the range Yanbu was quite a bit I am just curious how are you thinking about that in today's environment. That's a wider range is is that something that you intend to depending on the market opportunity set that you are seeing today in the marketplace of operating close to the upper end of that range.

<unk> or is that something where you guys are comfortable sort of where are you at are at today, and you're kind of giving yourself. Some more cushion in case there is further disruption.

In the credit markets going forward.

Thanks for the question, it's really the latter.

It is we don't really have a plan to to generally speaking the operating in the upper end of that range, but we do want to maintain the flexibility around.

Spectation with our shareholders and with the rating agencies that if there is a.

A market event or an economic event that creates the opportunity for us to realize.

For us too.

Originating well structured and well priced loans, especially something like a rescue lending opportunities that we may see over the next 12 to 18 months, we'd like the ability to be able to do that and not surprise anybody.

That's really the cause for the widening of that range, but it's not with the expectation that we will generally and consistently be operating at the upper end.

Okay understood.

I had a question on the you talked a lot about the primary markets in both the sponsor and non sponsor I had a question in the secondary markets. You guys are obviously very active in that marketplace. I think you guys put up a slide slide number seven I think is a.

Very helpful illustration of your guys' willingness to step in and kind of.

Dislocation in the liquid markets I'm curious.

Loan prices are generally kind of trended a little bit higher.

In the third quarter calendar third quarter are you still seeing that same sort of opportunity set that you saw in the second quarter and the secondary liquid markets or not.

Okay.

Yes.

The.

I would say generally speaking the market has moved higher both in high yield bond Bandon senior loans high yield is up 6% in July senior loans are up one 8% in July .

And that's it.

Obviously, a move in the right direction.

Yes, but.

There isn't a lot of liquidity in the market either on the buy side or the sulfide. So it doesn't take much to move pricing either up or down.

So one month a trend does not make.

So I'm not sort of closing the book in calling a good.

But I would say generally speaking the prices have moved in a direction, where we are not really investing.

Rapidly we think that there is sort of more volatility ahead in the economy and probably in the markets and there is sort of a temporary fund flows.

Factor here that is driving prices higher or has driven prices higher in July .

But I would expect further volatility so we continue to be prudent we're not going to chase the market higher.

And so we've been we were fairly active in the in the second quarter and we will be active again, but.

But.

Yes.

We don't think that the secondary buying opportunity is necessarily over at this point.

And we're going to just kind of continue to watch it.

Look to add when the time is right.

Okay.

Understood.

Thanks for taking my questions I appreciate the time today.

Thank you.

Again, if you have a question. Please press Star then one.

Our next question comes from Melissa Wedel of J P. Morgan. Please go ahead.

Good morning, Thanks for taking my question today.

You actually answered a few of them already but I was hoping we could touch on timing of activity in the June quarter.

Wondering if activity was particularly skewed towards the back ended the quarter.

And maybe not fully maybe the top line not fully reflecting.

On the earnings power of that the new investment.

Was there anything like that going on in Q and the June quarter.

Yes, I'll hand that over to Chris.

Maybe Chris or Matt Stuart.

Either of you have a view on that timing I know it did it did have an impact but they can give you a more refined response.

Yes, thanks for the question.

Yes.

I would say that it was.

Not so much of a tiny matter so much as it was.

Matter related to.

<unk> please.

Starting to see the impact of the rising reference rates during the quarter.

A good portion of the portfolio did not reset until June 30th So as I mentioned in my prepared remarks, we did try to provide some color around the fact that if you're able to.

June 30 rates that had been in effect as of March 31.

Adjusted NII all else equal would have been up about a penny a share for the quarter. So that was more of a driver versus the timing of deployment.

Okay. That's helpful. Thank you that's it for me.

We have no further questions Mr <unk>.

Great. Thanks, Sanjay and thank you all for joining us on today's earnings conference call. A replay of the call will be available for 30 days on <unk> website in the investors section or by dialing 870, 734 475 to nine for U S callers or one four.

Our 123170088 for non U S callers with the replay access code.

7421084.

Beginning approximately one hour after this broadcast.

The conference has now concluded. Thank you for attending today's presentation you may now disconnect.

Q3 2022 Oaktree Specialty Lending Corp Earnings Call

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