Oaktree Specialty Lending : Q2 2021 Oaktree Specialty Lending Corporation Earnings Conference Call Transcript

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Q2 2021 Oaktree Specialty Lending Corp Earnings Call

EVENT DATE/TIME: MAY 06, 2021 / 3:00PM GMT

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MAY 06, 2021 / 3:00PM GMT, Q2 2021 Oaktree Specialty Lending Corp Earnings Call

CORPORATE PARTICIPANTS

Armen Panossian Oaktree Specialty Lending Corporation - CEO & CIO

Mathew M. Pendo Oaktree Specialty Lending Corporation - President & COO

Mel Carlisle Oaktree Specialty Lending Corporation - CFO & Treasurer

Michael Mosticchio Oaktree Specialty Lending Corporation - IR

CONFERENCE CALL PARTICIPANTS

Bryce Wells Rowe Hovde Group, LLC, Research Division - Research Analyst

Devin Patrick Ryan JMP Securities LLC, Research Division - MD and Equity Research Analyst

Finian Patrick O'Shea Wells Fargo Securities, LLC, Research Division - VP and Senior Equity Analyst

Kyle M. Joseph Jefferies LLC, Research Division - Equity Analyst

Melissa Marie Wedel JPMorgan Chase & Co, Research Division - Analyst

Ryan Patrick Lynch Keefe, Bruyette, & Woods, Inc., Research Division - MD

PRESENTATION

Operator

Welcome and thank you for joining Oaktree Specialty Lending Corporation's Second Fiscal Quarter 2021 Conference Call. Today's conference call is being recorded. (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.

Michael Mosticchio Oaktree Specialty Lending Corporation - IR

Thank you, operator, and welcome to Oaktree Specialty Lending Corporation's Second 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 oaktreespecialtylending.com.

Our speakers today are Armen Panossian, Chief Executive Officer and Chief Investment Officer; Matt Pendo, President and Chief Operating Officer; and Mel Carlisle, Chief Financial Officer and Treasurer. We will be happy to take your questions following their prepared remarks.

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, the ability to realize the anticipated benefits of the merger and 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 in further detail. We undertake no duty to update or revise any forward-looking statements.

I'd 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 website.

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

Mathew M. Pendo Oaktree Specialty Lending Corporation - President & COO

Thank you, Mike, and welcome, everyone. We appreciate your interest in and support of OCSL, and we hope everyone listening is well. We continued to generate momentum in the second quarter with earnings, origination activity and credit quality all strong.

We reported NAV per share of $7.09, up 4% from the prior quarter. The increase reflected both continuing market spread tightening and price appreciation on certain liquid debt investments during the quarter. As with last quarter, our NAV continues to exceed its pre-COVID high and is up more than 7% from the end of calendar 2019. We continued to produce steady strong results. Adjusted net investment income per share, which excludes the impact of asset acquisition accounting related to the merger with Oaktree Strategic Income Corporation was $0.14, up slightly from the prior quarter.

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MAY 06, 2021 / 3:00PM GMT, Q2 2021 Oaktree Specialty Lending Corp Earnings Call

Based on our consistent performance and confidence in the potential to further improve earnings, our Board increased our quarterly dividend by 8% to $0.13 per share, the fourth consecutive quarterly increase. This also marked a 37% increase from a year earlier.

We continue to actively identify attractive new deals, during the quarter, and excluding the assets we acquired as part of the OCSI merger, we originated $318 million of new investment commitments. Of these, 80% were first lien loans.

Originations this quarter demonstrated the breadth of Oaktree's sourcing platform as new deals were spread across a variety of industries, real estate, software, industrials and to a mix of sponsor and non-sponsor businesses.

We received $229 million from paydowns and exits in the quarter. These were mostly composed of second liens, unsecured debt and lower-yielding investments. Notably, exits included our position in Airbnb, which generated $2 million of prepayment income that contributed to earnings.

The weighted average yield on our new debt investments in the quarter was 8.2%, which compares favorably to the average yield of 6.8% on investments that we exited.

We continue to identify opportunities and structure deals with attractive yields despite the low interest rate environment. That noted, we are approaching new investments cautiously given some lingering uncertainty about the pandemic in both the timing and durability of a full recovery.

With that in mind, our credit quality remains exceptional. We further reduced noncore holdings during the quarter, exiting 3 positions. Noncore investments, including the $32 million of noncore investments acquired from OCSI, now represent $164 million or only about 7% of the portfolio at fair value.

Before I turn the call over to Armen, I'd like to spend a few moments discussing the closing of the merger with OCSI, which occurred on March '19. As we have emphasized previously, we believe that this transaction has resulted in several benefits to OCSL, including a larger, more scaled BDC with $2.3 billion of assets, up from $1.7 billion in the prior quarter; an improvement in portfolio diversity, including an increase in first lien loans to 68% of the portfolio at fair value, from 60%; and increased trading liquidity. And we also expect the merger to be accretive to NII over both the near and long-term through cost savings and the 2-year fee waiver.

In addition, part of our rationale for the merger was improved access to more diverse, lower-cost funding sources. Since quarter-end, we have been hard at work making improvements to our capital structure.

Earlier this week, we amended our syndicated credit facility, increasing the size to $950 million from $800 million and extending maturity by 2 years to 2026. We also retired a higher cost credit facility that was acquired from OCSI. While there is still some more to be done, we believe these actions position us well to optimally fund investments and will help reduce our overall cost of debt capital.

Overall, we are very pleased with the quarter and our results year-to-date and the completion of the merger. We are confident the scale we now have will help drive further benefits for our shareholders.

With that, I will now turn the call over to Armen.

Armen Panossian Oaktree Specialty Lending Corporation - CEO & CIO

Thanks, Matt, and good morning, everyone. The credit and equity markets continue to advance along with declining unemployment, an improving economy and forecast for strong GDP growth in the second half of 2021. Vaccine rollout programs, while varied by country, have proven successful to date overall in the United States and other developed countries, adding to optimism. We share in the confidence and yet, ours is cautious optimism. Exceptional fiscal and monetary stimulus has supported the recovery and helped fuel investor confidence, liquidity and the availability of credit.

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MAY 06, 2021 / 3:00PM GMT, Q2 2021 Oaktree Specialty Lending Corp Earnings Call

We believe equity valuations already reflect expectations for strong economic growth and therefore, may be inflated as the ultimate success of vaccinations and corresponding GDP expansion still remain uncertain. Mindful of that uncertainty, we continue to approach new investments defensively, guarding against the downside in our investments and securing appropriate compensation for risk.

All of that noted, we are actively investing in generating strong risk-adjusted returns for our shareholders. We are drawing upon the full breadth of Oaktree's scale and resources to invest across multiple markets with a diversified group of issuers.

We are further building the portfolio with investments from consistently performing companies and in sectors that present relatively low risk, notably including those that proved resilient throughout the pandemic, from life sciences to application software. We are also lending to businesses that are not easily underwritten via traditional cash-flow-based methodologies, and we continue to carefully study the rescue lending landscape, an area in which we have found appealing opportunities.

We also continue to pursue unique opportunities where competition is limited, leveraging Oaktree's ability to negotiate and structure customized private deals that provide downside risk management by mitigating specific risks of the issuer.

Now turning to the overall portfolio.

At the end of the second quarter, the portfolio was well diversified with $2.3 billion at fair value across 137 companies. The portfolio grew as a result of the $504 million of assets we acquired from OCSI and net new investment fundings.

86% of the portfolio was invested in senior secured loans. Our median portfolio company EBITDA at March 31 was approximately $100 million, as we continue to focus on lending to larger, more diversified businesses. Credit quality continues to be excellent. In addition to having no portfolio companies on nonaccrual, amendments and modifications are very low.

Turning now to investment activity. During the quarter, we found numerous opportunities in companies with attractive risk-reward profiles, as well as unique opportunities requiring especially structured terms.

I'd like to highlight our investment in NN, Inc. as an excellent example. NN, Inc. is a diversified industrial company that designs, manufactures and sells high-precision components for a variety of industries, including the electrical, automotive, general industrial, aerospace, defense and medical markets. It has a number of growth initiatives underway and is poised to expand alongside several of its end markets. The company sought a total of $265 million in new credit to pay off maturing debt and to fund its ongoing growth. Oaktree provided a $150 million term loan due 2026 with attractive pricing at LIBOR plus 6.875%. As a condition to providing our loan, the borrower was required to raise preferred equity that would be subordinated to our position. OCSL was allocated $60 million of the loan total.

Other compelling investments during the quarter, all attractively priced, included a $40 million loan to Sunland Asphalt & Construction, which provides specialty contract services for roads, parking lots and artificial sports field services. A $30 million loan to Inventus Power, which engineers and manufactures battery packs and power supplies for the commercial, medical and government markets. And a $13 million follow-on preferred equity investment in Thrasio, which consolidates popular brands that sell their goods, mainly via Amazon's marketplace.

Our strong liquidity, coupled with the resources of Oaktree, positions us very well to continue identifying unique and attractive opportunities in both public and private investments. Now I will turn the call over to Mel to discuss our financial results in more detail.

Mel Carlisle Oaktree Specialty Lending Corporation - CFO & Treasurer

Thank you, Armen. Good morning, everyone. Before getting into the discussion of the income statement, I would like to discuss the GAAP accounting that is related to our merger with OCSI because of its unique treatment of asset valuations.

Although the merger was structured as a NAV-for-NAV exchange under GAAP, the merger was accounted for using the asset acquisition method. Under this framework, the fair value of the consideration paid by OCSL to acquire OCSI was based on the number of OCSL

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MAY 06, 2021 / 3:00PM GMT, Q2 2021 Oaktree Specialty Lending Corp Earnings Call

shares issued and stock price immediately prior to the merger close, with a small adjustment for OCSL's capitalized merger cost.

Because OCSL was traded at a discount to NAV at closing, the final consideration paid resulted in a $34.1 million purchase discount for the net assets of OCSI relative to their fair value. This purchase discount was allocated pro rata based on a fair market value to former OCSI assets.

As a result, OCSL's initial cost basis for the assets equaled their fair value at the time of the merger, less the purchase discount. Immediately upon the close of the merger, OCSL recognized a onetime unrealized gain equal to the total purchase discount of $34.1 million, as we remarked the assets back to their fair value. This one-time gain was a noncash event. Going forward, each individual debt investment acquired from OCSI will amortize from its new cost basis as established by the purchase accounting treatment back to par over its remaining life or will be accelerated if the investment is exited before maturity.

Importantly, we have amended our investment advisory agreement to revise the calculation of incentive fees to ensure that any net accretion income or net realized gains arising solely from the merger accounting treatment will have no impact on the incentive fees payable to Oaktree. Once again, this will be a noncash event every quarter. In the second quarter, in addition to the one-time unrealized gain, we also recorded $665,000 of discount accretion income as a result of the merger accounting.

We have introduced several non-GAAP measures to supplement our GAAP financials in order to make the company's post-merger financial results easier to understand and more comparable to our results prior to the merger. These non-GAAP measures are intended to remove the impact of the income accretion as well as any net realized and unrealized gains or losses arising solely from the merger accounting adjustments.

More information about these supplemental disclosures can be found in our earnings release and slide presentation.

Now turning to the financial results of the second quarter. After removing the merger-related accretion, total investment income was $41.3 million, up from $38.2 million in the prior quarter. The $3.1 million increase was mainly due to our larger portfolio resulting from both stronger originations and the OCSI portfolio that we acquired.

Net expenses for the second quarter totaled $23.8 million, down $4.4 million sequentially. The decrease was driven by lower accrued Part II incentive fees. This was partially offset by higher interest expense and base management fees, mainly due to an increase in borrowings outstanding and our larger investment portfolio, respectively.

Additionally, Part I incentive fees and professional fees were both modestly higher on a sequential basis.

For the quarter, OCSL reported adjusted net investment income of $21.1 million, up slightly from $19.6 million in the December quarter.

Adjusted NII was $0.14 per share for both quarters.

During the second quarter, OCSL accrued a total of $3.6 million in Part 2 incentive fees. This amount was mostly due to $37 million in net realized and unrealized gains in the portfolio during the quarter. Excluding the one-time unrealized gain of $33.4 million due to the merger accounting.

As a reminder, while GAAP requires us to take unrealized gains into account when accruing Part II incentive fee expense each quarter, OCSL will only pay Part II incentive fees annually and to the extent that it has realized gains that exceed realized and unrealized losses at OCSL's September 30 fiscal year-end.

To date, we have accrued $13.1 million of Part II incentive fees under GAAP. However, if Part II incentive fees were hypothetically calculated as of March 31, 2021, under the investment advisory agreement, the amount payable would have been $3.1 million.

Turning to credit quality, which continues to be very strong. At quarter end, we had no investments on nonaccrual. This is down from one

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