Fitch Ratings affirmed the long-term issuer default rating, senior secured debt rating and senior unsecured debt rating of Oaktree Specialty Lending at ‘BBB-‘. The rating outlook was revised to stable from negative. The ‘A’ long-term IDR and stable rating outlook assigned to Oaktree Capital Management, Oaktree Specialty Lending’s external manager, are unaffected by these actions.
Key Rating Drivers
The rating outlook revision reflects Fitch’s belief that, following a recent covenant amendment, Oaktree Specialty Lending’s cushion to its minimum shareholders’ equity covenant will remain sufficient to withstand potential negative portfolio valuation marks and/or increased credit losses over the outlook horizon. The stable rating outlook also reflects Fitch’s view that Oaktree Specialty Lending’s asset coverage cushion will remain appropriate for its rating, despite the expectation for portfolio credit deterioration over the medium term, given its relatively low leverage at March 31, 2020 and lower target leverage range relative to peer business development companies. Fitch also expects Oaktree Specialty Lending to maintain sufficient liquidity and solid dividend coverage over the outlook horizon.
On May 6, Oaktree Specialty Lending entered into an amendment to its credit facility, which reduced the minimum shareholders’ equity covenant to $550 million from $700 million. Based on Oaktree Specialty Lending’s net assets of $752.2 million at fiscal Q2/20 and a portfolio at fair value of $1.4 billion, the cushion to the new covenant increased to 14.5% of the portfolio at fair value at fiscal Q2/20 from 3.8% of the portfolio prior to the amendment. Fitch views the improvement in the cushion to the covenant favorably, particularly since the borrowing capacity under the credit facility was unchanged at $700 million. Fitch believes the cushion has further increased following the end of fiscal Q2/20, as Oaktree Specialty Lending’s net asset value has likely benefited from the improvement in liquid market valuations in recent weeks given its exposure to broadly syndicated loans, which have an available market quote. At March 31, Level 2 investments accounted for 35% of Oaktree Specialty Lending’s portfolio at fair value, which was well-above the peer average.
The rating affirmations reflect Oaktree Specialty Lending’s affiliation with Oaktree Capital Group, which has a strong and established track record in credit and provides the BDC with access to investment resources, risk management and monitoring capabilities and bank relationships, below-average leverage compared with rated BDC peers, declining exposure to legacy non-core investments, solid liquidity, and improved funding flexibility following the issuance of additional unsecured debt in February 2020.
Rating constraints specific to Oaktree Specialty Lending include its short operating history under the current management team, which makes it more challenging to assess the company’s through-the-cycle middle market underwriting acumen, although this is somewhat mitigated by Oaktree’s strong track record in other credit funds/vehicles. Other constraints include higher-than-peer exposure to second lien investments, continued exposure to certain legacy non-core investments, and the potential for its portfolio to experience above-average valuation volatility given exposure to broadly syndicated loans.
Rating constraints for the BDC sector more broadly include the market impact on leverage, given the need to fair-value the portfolio each quarter, dependence on access to the capital markets to fund portfolio growth and a limited ability to retain capital due to dividend distribution requirements. Additionally, the competitive underwriting environment over the last several years has yielded deterioration in terms in the middle market, including fewer/looser covenants and higher underlying leverage. Fitch believes a sustained slowdown in the economy resulting from the coronavirus pandemic is likely to translate to asset quality issues more quickly, given the limited embedded financial cushion in most portfolio credits and weaker lender flexibility in credit documentation. Recently relaxed regulatory limits on leverage are an evolving sector headwind, which could contribute to increased risk profiles for individual BDCs.
Oaktree Specialty Lending’s leverage, as measured by par debt-to-equity, was 0.94x at fiscal Q2/20, below the rated peer average but above the firm’s previously articulated target leverage range of 0.70x-0.85x. That written, leverage would have been lower at 0.82x if adjusted for cash on the balance sheet, which increased during the quarter as Oaktree Specialty Lending sought to bolster its liquidity in the uncertain environment. In May 2020, in connection with reporting its fiscal Q2/20 earnings results, Oaktree Specialty Lending announced an increase in its target leverage range to 0.85x-1.00x. Fitch views the increase in the leverage target unfavorably, but notes that the firm’s targeted leverage range remains below that of rated BDC peers that are subject to a 150% asset coverage requirement. Fitch views Oaktree Specialty Lending’s new target leverage range as appropriate for its rating level and its portfolio risk profile. While not currently anticipated, should Oaktree Specialty Lending decide to increase leverage above 1.00x, Fitch expects that the increase in leverage would be accompanied by a reduction of portfolio risk, as evidenced by an increase in exposure to first lien positions.
The leverage ratio implied an asset coverage cushion of 27.4% at March 31, 2020, which is within Fitch’s ‘BBB’ category leverage benchmark range of 11%-33%. Fitch believes that Oaktree Specialty Lending will selectively deploy capital into new investments and support existing portfolio companies, which, when combined with the potential for higher losses over the medium term, could result in an increase in leverage. Still, Fitch expects Oaktree Specialty Lending’s asset coverage cushion will remain appropriate for the rating category since leverage is expected to remain within the firm’s targeted range. Fitch estimates that Oaktree Specialty Lending can sustain a decline in its portfolio at fair value of more than 19%, based on fiscal Q2/20 metrics, before the firm’s asset coverage cushion falls to the low-end of Fitch’s ‘BBB’ category range of 11%-33%.
Oaktree Specialty Lending’s asset quality metrics improved following exits of certain underperforming legacy investments over the past year. At March 31, 2020, investments on non-accrual status accounted for 0.5% of the debt portfolio at fair value and 1.9% at cost, down from 6.6% and 12.3%, respectively, a year ago. Fitch believes that Oaktree Specialty Lending benefits from Oaktree’s expertise in restructuring balance sheets to maximize recoveries. Oaktree Specialty Lending experienced net realized gains amounting to $20.8 million during fiscal 2019, or 1.4% of the average portfolio at fair value, compared with net realized losses representing 7.6% of the average portfolio at fair value in fiscal 2018. Excluding a loss related to the extinguishment of debt, net realized losses amounted to $20.7 million, or 1.5% of the average portfolio, in the first fiscal half of 2020. While Fitch believes Oaktree Specialty Lending’s exposure to borrowers in the hardest hit corporate sectors, such as travel, leisure, retail and energy is manageable, social distancing guidelines have pushed the U.S. economy toward a recession, which will have credit implications for the entire portfolio. Fitch expects non-accrual and/or realized loss metrics to tick up throughout 2020, but would view meaningful realized losses negatively, particularly losses from investments originated by Oaktree.
Earnings and dividend coverage also are expected to be challenged for the sector in the coming quarters, as interest rates have declined (although the presence of LIBOR floors and declining funding costs will serve as partial mitigants) and non-accruals and paid-in-kind (PIK) interest are expected to increase across the sector. Fitch estimates that Oaktree Specialty Lending’s after-tax net investment income (NII), adjusted for any reversal or accrual of capital gains incentive fees not waived and not currently payable in cash, coverage of dividends declared amounted to 125.5% in fiscal 2019 and 119.0% in the first fiscal half of 2020. Adjusting for total non-cash income and expenses, dividend coverage was lower at 86.5% in fiscal 2019 and 90.8% in the first fiscal half of 2020. The lower coverage on a cash basis is partially driven by elevated accretion of original issue discount on investments. PIK interest income has been more modest, but will likely increase across the sector in 2020.
Fitch believes Oaktree Specialty Lending has sufficient liquidity to fund draws on portfolio company revolvers, which have slowed in recent weeks, and to work with underperforming portfolio companies in the coming months in an effort to maximize recoveries, if necessary. At March 31, 2020, Oaktree Specialty Lending had $89.5 million of balance sheet cash and equivalents and $295.2 million of undrawn capacity under its secured credit facility (subject to borrowing base and other limitations). The firm had $91.6 million of unfunded commitments to portfolio companies, of which approximately $60 million could be drawn immediately. The remaining amount was subject to certain milestones that must be met by portfolio companies before the commitment becomes available. Fitch expects Oaktree Specialty Lending’s liquidity position to remain sound, given the relatively low level of unfunded commitments.
In February 2020, Oaktree Specialty Lending issued $300 million of five-year unsecured notes and utilized proceeds to redeem $161.3 million of unsecured notes and pay down borrowings under its revolving credit facility. At March 31, 2020, unsecured debt represented 42.6% of total debt outstanding (at par), which is up from 27.0% a year ago and within Fitch’s ‘BBB’ rating category quantitative benchmark range of 35%-50% for BDCs. Fitch expects unsecured debt to continue to represent at least 35% of total debt outstanding over time.
The alignment of the unsecured debt rating and secured debt rating with that of the long-term IDR reflects solid collateral coverage for all classes of debt given that Oaktree Specialty Lending is subject to a 150% regulatory asset coverage requirement.
Factors that could, individually or collectively, lead to negative rating action/downgrade include an inability to maintain its cushion to covenants at a level viewed as sufficient to account for incremental valuation volatility and/or credit deterioration in the portfolio over the medium term, a decline in the asset coverage cushion to below 11%, a sustained increase in leverage above 1.00x without an improvement in the portfolio risk profile and/or a material decline in first lien positions or a shift in focus toward subordinated debt or equity investments without a commensurate decline in leverage, a sustained increase in non-accrual levels, meaningful realized losses and/or meaningfully weaker cash-based NII coverage of the dividend.
Fitch believes that the recent increase in the leverage target and the challenging economic backdrop from the coronavirus pandemic limit the likelihood of positive rating momentum over the medium term.
However, factors that could, individually or collectively, lead to positive rating action/upgrade longer term include strong and differentiated credit performance of recent vintages, evaluated in combination with the consistency of Oaktree Specialty Lending’s operating performance, asset quality metrics, investment valuations and underlying portfolio metrics. An upgrade also would be conditioned upon the maintenance of sufficient liquidity, the maintenance of leverage within the targeted range, such that the asset coverage cushion is commensurate with the risk profile of the portfolio, solid dividend coverage and the maintenance of unsecured debt above 35% of total debt outstanding.
The secured and unsecured debt ratings are primarily linked to the long-term IDR and are expected to move in tandem. However, a material reduction in unsecured debt as a proportion of total debt could result in the unsecured debt rating being notched down from the IDR.