Oaktree Specialty Lending: An 11% Yield That Feeds On Pain

Mastering The Market Cycle With Howard Marks

An excellent book covering the market cycle of specialty credit is Howard Marks' In the book he details the specific situations under which specialty lenders can take advantage of times when the credit window "begins to shut" and capital becomes more difficult to come by. The Oaktree Specialty Lending Corporation (NASDAQ:OCSL) is a $3.2 Billion fund set up to take advantage of the pain that a difficult lending environment presents. The aforementioned book details the simple mantra of the company when looking at distressed debt, "good company, bad balance sheet".

In essence, Oaktree and Howard Marks expect profitability to be at its maxim in times of high interest rates and economic turmoil. When borrowing is easy, or as Marks says the "window is wide open", the fund is not as profitable. If Mark's profitability in the last credit tightening cycle is an indicator of future opportunities, this could be an excellent entry point before general business loans become more difficult to attain.

Yield history

Here we can see the record of the yield versus history. A large run-up in yield occurred in the GFC of 2008-2012. Marks, along with Michael Burry, Steve Eisman, and Jamie Mai are all well-noted profiteers of the huge housing crisis that led to a credit tightening cycle the like of which had not been seen for decades. At this point, not only did the yield of this closed-end fund spike but so did the share price:

As seen from the above, this fund is at its most profitable, and valuable in times of pain. Mastering The Market Cycle does a great job of detailing the theorem behind the profitability with an excellent analogy to the credit window.

Credit spreads as the window shuts

My summation of what Marks describes as the credit cycle in a nutshell:

The credit window can be seen as being wide open during times of low-interest rates, low capital reserve requirements, and economic boom cycles in which see capital appreciation of both paper and physical assets. Lenders are eager to close as many loans as possible. Appraisals always come in for what the lender needs to clear and close the loan. They fear not for capital loss since there is ample credit available to refinance should a borrower need to use outside capital to repay the borrowed capital. As asset prices inflate, there is no fear that the borrowers will be underwater and unable to repay or refinance.

As rates rise, refinancing becomes more difficult. Lender's funds become more precious as their cost of capital increases when forming overnight loan syndications and when customers begin to sort cash into higher-yielding accounts and products. Bankers become more judicious and the window begins to shut. Marks likes to call this adding logs to the fire. Finally, a spark ignites and the credit market becomes a tinderbox. The window slams shut for all but the most worthy of borrowers. The credit cycle has now gone full circle.

Marks also lists the progression of the lender terms from window open to window shut along the following lines:

• When eager, lenders fight to make the cheapest loans with the lowest rates.
• When eager, lenders offer the weakest bespoke covenants, contingencies, and terms.
• When eager, lenders are both willing to make cheap loans with weak covenants at low positions in the capital stack.

The reverse happens when the window shuts:

• Lenders want higher rates.
• Lenders want stronger covenants, contingencies, and terms.
• Lenders want a higher position in the capital stack and may be unwilling to lend at any rate.

The window shutting makes for many businesses to seek out alternative lending sources as they find it more difficult to find traditional financing. These specialty lenders can ask for very strong terms at high rates.

Targets

From the Oaktree Specialty Lending 10K:

We generally invest in securities that are rated below investment grade by rating agencies or that would be rated below investment grade if they were rated. Below investment grade securities, which are often referred to as "high yield" and "junk," have predominantly speculative characteristics with respect to the issuer's capacity to pay interest and repay principal.

Again, the goal is to seek out the "good company with a bad balance sheet". In this situation, what is the lender's motivation should these companies be at risk of default?

Normally investors buy debt securities or make loans because they expect to be paid interest periodically and have their principal repaid when the debt matures. With distressed debt, however, the consensus is that these things won't occur: instead it is expected that the debt won't "stay current" or "be serviced". So if interest and principal aren't expected to be paid, what is the distressed debt investor's motivation?

The answer is that debt-holders who aren't paid as scheduled have a "creditor claim" against the debtor. In short-and to oversimplify- when a company goes through bankruptcy, the old owners are wiped out and the old creditor becomes the new owner.- Howard Marks, Mastering The Market Cycle pg. 162

In essence, one strategy for profitability at Oaktree is to negotiate the best covenants to have an asset at a steep discount that they can profit on should the company go into receivership. These covenants are very difficult to negotiate with quality companies when the window is open but easy when shut.

Portfolio makeup

The fund rate structure:

• Floating rate 86%
• Fixed rate 14%
• 12.3% yield on debt
• 76% first lien

• Long-term debt to equity ratio of 0.90x to 1.25x (i.e., one dollar of equity for each $0.90 to $1.25 of debt outstanding.

Company type and composition

Here we can see an outsized proportion of software in the portfolio makeup. Specialty credit and private lenders prefer "asset-light" companies that have smaller amounts of hard asset capex requirements. Hard asset companies also have the added complication of subordinate loans and rights attached to real property should they move to take the company whole. Software and biotech/life sciences companies are two specialties of Oaktree as described in their fund's 10K:

In these instances, a debt-to-EBITDA approach may not be appropriate, instead requiring a value-oriented approach that involves targeting low loan-to-value ratios and negotiating highly-structured investments with bespoke covenants, contingencies and terms that help mitigate business-specific risks. Examples of these opportunities may include life sciences companies that are unable to access traditional bank financing to commercialize their product pipelines.

Fund focus

The fund institutes a variety of profit strategies. The aforementioned private strategies have been covered. Public credit and commercial paper are the funds' other, secondary focus. Capital appreciation for buying securities and debt under par and riding them back to par is another technical investment aspect of the fund. With the rise in rates, several debt issuances have been hammered to levels well below par while the borrower remains creditworthy enough to return funds at maturity.

Rates are higher for longer

Incoming Co-CEO of Oaktree CEO Armen Panossian had a recent interview where he said the company believes a recession will lag about 18 months behind the start of the rate increases. In line with the ethos of Howard Marks, he believes that rates being "higher for longer" in the face of an interim strong economy will begin to deflate asset bubbles from the last decade. He is expecting access to capital to become more difficult which in turn will spurn the recession.

Mastering the Market Cycle also mentions this. When asset values deflate and go underwater from the value for which they first gained financing, traditional re-financing will become impossible as collateral evaporates. This collateral evaporation from asset bubble deflation will push many borrowers to specialty, private lenders.

Parting insights from Howard Marks

Although Marks no longer runs Oaktree, he does write consistent memos that are posted on the company website. The most recent is from today, October 11th, 2023. The title is Further Thoughts On Sea Change, the very verbiage that Panossian sprinkles into his CNBC interview. The memo covers the oddities of the rate environment that has been so kind to asset prices since 2009.

Relatively few investors today are old enough to remember a time when interest rates behaved differently. Everyone who has come into the business since 1980 - in other words, the vast majority of today's investors - has, with relatively few exceptions, only seen interest rates that were either declining or ultra-low (or both). You have to have been working for more than 43 years, and thus be over 65, to have seen a prolonged period that was otherwise. And since market conditions made it tough to find employment in our industry in the 1970s, you probably had to get your first job in the 1960s (like me) to have seen interest rates that were either higher and stable or rising. I believe the scarcity of veterans from the '70s has made it easy for people to conclude that the interest rate trends of 2009-21 were normal.

In the memo Marks also believes that government rescue plans and stimulus will be less likely in the face of rampant inflation. They should not be expected.

As noted above, to fight the GFC, the Fed took the Fed funds rate to roughly zero for the first time in late 2008. Macro conditions were frightening, as a vicious cycle capable of undermining the entire financial system appeared to be underway. For this reason, aggressive action was certainly called for. But I was shocked when I looked at the data and saw that the Fed kept the rate near zero for nearly seven years. Setting interest rates at zero is an emergency measure, and we certainly didn't have a continuous emergency through late 2015. To me, those sustained low rates stand out as a mistake not to be repeated.

Importantly, this distorts the behavior of economic and market participants. It causes things to be built that otherwise wouldn't have been built, investments to be made that otherwise wouldn't have been made, and risks to be borne that otherwise wouldn't have been accepted. There's no doubt that this is true in general, and I'm convinced it accurately describes the period in question.

But still, I think the easy times - and easy money - are largely over. How can I best communicate what I'm talking about? Try this: Five years ago, an investor went to the bank for a loan, and the banker said, "We'll give you $800 million at 5%." Now the loan has to be refinanced, and the banker says, "We'll give you $500 million at 8%." That means the investor's cost of capital is up, his net return on the investment is down (or negative), and he has a $300 million hole to fill.

An 11% yield that may be on the upswing

If credit spreads continue to increase as the risk-free rate marches upward, the profitability of specialty lending will only be enhanced. The fund follows a similar rule to money market funds in that no single investment can represent more than 5% of the fund's investments. You do not have to fret about a concentrated bet into one distressed borrower or ultra-high-yielding security.

My strategy

I have started buying this fund and plan to hold it as long as rates continue to do what they currently are doing, staying high to rising. I would expect in a recession like the previous GFC that saw Oaktree Specialty Lending's yields spike and share price appreciate, this fund should do well.

I am not reinvesting the large dividend, rather will use it to invest into broad-based equities that I plan to hold for the long run. Should fiscal stimulus and rate cuts come into the picture without a recession, thus prolonging asset bubbles, I would trade out of the fund, hopefully with a nice profit. In short, I will hold and buy this fund as long as the credit window appears to be closing, ever so slowly.

Summary

I am a generally optimistic person, I buy equities in all environments. Marks and Oaktree, as evidenced by the recent Sea Change memo, seem to be taking a long term pessimistic view. Things seem to work themselves out, but temporary periods of pain are inevitable. This is one of my favorite hedges should that pain materialize. Buy.