Description

I recommend purchasing Oaktree Specialty Lending Corp. (OCSL) for investment under substantially the same propositions that I offered up its predecessor Fifth Street Finance Corp. (FSC) two years ago, with the exception that it is now an even better investment because:

1. All of the major uncertainties that existed at the time of the prior writeup are now resolved; and,

2.  The discount is even larger now than it was then.  

I expect the stock to trade toward 1.0 times its current NAV of $6.60 per share.  This, plus the 38 cents in dividends I expect to be paid out over the coming year should yield a 35% total return. 

On August 12, 2017 I wrote up Fifth Street Finance Corp. (FSC) at a 26% discount to the NAV it reported at the time of $7.17.  My thesis was that over the next year I expected the NAV to ultimately settle out at $6.45 per share and that the stock would trade at 1.0 times this number, in line with where comps were trading.  

I proposed that the combination of price appreciation from the trading price at the time of the writeup (which was $5.29 per share) to my $6.45 expected future price, plus the 42 cents in dividends I expected to be paid out, would yield a total return of 30% (i.e., equal to $6.87 divided by $5.29).

My attempt at an objective debrief of the idea and its performance is as follows:

Expectation 1:  The transaction between Oaktree and Fifth Street Asset management would close, leaving FSC with a vastly more respected manager, more aligned fees, and infinitely greater confidence in NAV reporting and performance going forward.

Outcome:  EXPECTATION MET.  The deal closed as expected.  FSC became Oaktree Specialty Lending Corp (OCSL) on October 13, 2017.  Tannenbaum and his conflicted team are out, and grownups are now managing the portfolio.  The management fee has been lowered from 1.75% to 1.5%, the incentive fee from 20% to 17.5%. 

Expectation 2:  Over the coming year, at least 42 cents in dividends would be paid out.

Outcome:  EXPECTATION MET. 43 cents were paid out:  12.5 cents each on 9/29/17 and 12/29/17, 8.5 cents on 3/30/18, and 9.5 cents on 6/29/18.

Expectation 3:  The NAV would ultimately settle at, or above, $6.45 per share.

Outcome:  EXPECTATION MET. That is, technically, and only because I’m relying a lot on the word “ultimately”.  The reported NAV trended down rather significantly for two quarters after the transaction before finally settling at $6.60 per share as of the latest filing for the quarter ending June 30, 2019.  The reported NAV versus the $6.45 expectation is charted below:

In the messages section of my prior writeup, others mentioned that Oaktree was significantly incentivized to mark down the portfolio after taking it over.  My response was that I could see the incentives but could not predict the extent to which they would do that. My view was that even if they did drastically undermark the portfolio, the reported NAV would eventually normalize back to the true value as Fifth Street legacy investments were transitioned to Oaktree core investments.  Reasonable minds can come to different conclusions as to what actually happened based on the above chart and one additional point: while the OCSL NAV has climbed rather dramatically since the end of 2017, the NAV of most other BDCs are flat to down.

It is important to note that even as the incentives for Oaktree to embed excessive conservatism in marking the portfolio was widely recognized, many believed the downtrend in NAV would continue, causing significant volatility in the shareprice as further writedowns were expected beyond what was reported through the end of 2017.  Below are some sample comments from VIC members from my prior writeup:

Post 1 by trev62:

Nice write up and very helpful background on the situation.  The obvious question to me is how did you get to the 10% number for the assumed haircut?  How confident are you that if there were big issues in the portfolio, Oaktree would have had time to figure that out and take the hit to NAV already?  I agree this will eventually trade in line or above the peers from a multiple perspective given the Oaktree involvement, but I'm less confident in what the true NAV is today. 

Post 2 by creditguy:

I expect large markdowns in the next quarter's report.  Fifth Street (and a number of the other low quality BDCs like Medley) are notorious for overmarking/mismarking positions.  Oaktree is highly incentivized to take a big bath on the marks in the next quarter. Anyone remember what happened to RSO after the company was sold and the external manager replaced.  Huge marks were taken in the subsequent quarter. Recall that Blackrock Kelso (another BDC) fired Kelso several years ago and Blackrock more than 2 years later is still dealing with the consequences of bad investment decisions made by the prior managers and has had to repeatedly write down positions.  You can not easily if at all trade out of private debt positions. Anyone remember the debacle of Oak Hill taking over the BDC that they did. Yes, part of the debacle is attributable to the energy focus but the lesson in this one and the Blackrock example is firing a poor investment manager does not solve the problem of the existing portfolio.  It will take years to sell and restructure these positions and I expect the big bath of writedowns in the next quarterly report.  

Post 4 by blaueskobalt:

I'm with creditguy.  Four points:

• the credits that are currently in the portfolio are likely worse than the average they have originated over their history. this is a natural consequence of their poor performance, hemorraging of talent and deterioration of sponsor relationships.  additionally, they have been shrinking for some time now; this, combined with the historically attractive refi market in the first half of this year, means that their portfolio is concentrated in companies that could not refinance.  

• You argue that 10% of NAV is an adequate margin of safety.  Their loss rate over the past five years (during a benign credit environment) has averaged over 6%; with current leverage, that is over 10% of NAV.  If you assume the legacy portfolio winds down in a straight line over three years with a 7% loss rate, that is $250mn in losses, which would be a 25% haircut to NAV.  Not saying that will happen, but there is a plausible path to far worse that 10% of NAV erosion.

• leverage is high--this will restrict their ability to originate quality paper as the legacy stuff rolls off, and it amplifies the impact of credit issues on NAV.  Not to mention the fact that FSC's lenders are concerned, an issue that was highlighted after Dalton took over the portfolio.

• how would you proceed if you were the Oaktree executive tasked with this project?  creditguy points out several cautionary tales. I would want to distance myself as much as possible from every legacy credit that gave me even the slightest concern.  I would want to build equity and build a margin of safety. This means markdowns, sales, lower leverage, lower returns, and the smallest dividend that I can get away with.

Post 11 by kalman951:

Rasputin998 – Thanks for the interesting idea.  I have a couple of questions now that Q4 2017 results have been released.  Would appreciate your thoughts on the following:

1. New Oaktree management wrote down NAV by ~14.0% which wasn’t too far from your 10.0% estimate.  It looks like the write-downs were primarily related to equity interests in various control investments and loans that were either in non-accrual status previously or newly went into non-accrual status during the quarter.  Most performing loans remain valued in the 90.0%+ of cost range. Given this, what do you think the likelihood is for additional write-downs moving forward as Oaktree continues to clean up the portfolio? It would seem to me that the biggest risk to NAV at this point is legacy investments falling into non-accrual given that the majority of them are still being valued very close to cost by new management.  Any thoughts on how we should think about quantifying this risk? Do you think NAV goes up or down for OCSL over the next 1-2 years?

2. There has been a number of questions comparing OCSL to BKCC.  Are there any additional BDCs that went through management changes over the past 5 years?  If so, how long did it take new management to “clean-up” the portfolio?

3. Given the two points above, it makes sense to me why OCSL would trade at a discount to NAV for now.  How long do you think it could be before the market gives OCSL credit for what should be a much stronger management team leading the company moving forward?

All of above concerns would have been worth heeding to avoid the vicious volatility in the shareprice that followed.  However, I am curious whether those same critics would agree that we are now very likely past the writedown and portfolio transition risks that they brought up at the time.  I think that both the NAV trend and the fact that Oaktree has been marking the portfolio for two years would say we are. 

As pointed out on the most recent earnings call, the portfolio transition is now substantially complete:

Edgar Lee, from latest earnings transcript on 8/7/19:

With these monetizations, non-core investments have declined from $893 million since we began managing OCSL to $273 million as of June 30. Of the remaining non-core investments, five are nonaccrual, totaling $87 million or 6% of the portfolio at fair value. We continue to work diligently on maximizing the values of our remaining investments, which we expect will continue to occur over time.

Expectation 4:  Given the respect Oaktree has earned in the marketplace, the shares should trade at, or above, 1.0x NAV since that would still be below where an average of less reputable comparables trade.

Outcome:  EXPECTATION EMPHATICALLY NOT MET. In fact, the shares are still well below the NAV multiple of comparables, despite the major risks having been essentially dissipated.  This is why I think this represents a much better investment today than at the time of my previous writeup.

The comparable list from my prior writeup is provided below, updated with today’s valuation data and the elimination of some merged entities:

Comparables 

Risks:

Recession.  However, this is somewhat mitigated by the portfolio’s current positioning and Oaktree’s history of generating exceptional returns when distressed opportunities abound.

Edgar Lee, from latest earnings transcript on 8/7/19:

Additionally, we maintained a conservative financial position during the quarter. We are exercising caution and discipline given the current market environment and the late stage of the economic cycle, and as a result, leverage was down slightly to 0.58x, below our long-term target range of 0.70x to 0.85x. That noted, we remain active in the market and are well positioned to take advantage of market dislocations as we have about $330 million of dry powder for new investments at quarter end.

Edgar Lee, further down:

In addition, we continue to weight the portfolio towards larger middle market companies with lower amounts of leverage. The median annual EBITDA of companies in our investment portfolio increased to $130 million in the quarter, up from $99 million in the same quarter one year ago, and 57% of our companies generated EBITDA in excess of $100 million. Leverage at our portfolio companies was 5.0x at quarter end, well below the overall market leverage levels of over 5.5x.

Catalyst

Time, continued steady performance.