Oaktree Specialty Lending: Get Ready for a Dividend Cut

In October, Oaktree Capital Group (OAK) took over the management of Fifth Street Finance, a troubled business development company. It renamed the company Oaktree Specialty Lending Corporation (OCSL -0.35%). But don't be confused -- for now, this is a new company in name only.

The underlying assets from which Oaktree Specialty Lending derives its value are the product of its old manager, Fifth Street Asset Management (NASDAQ: FSAM), a fact that becomes clear from its dismal fiscal fourth-quarter earnings report. On Wednesday, Oaktree Specialty Lending revealed that book value plunged $1.01 per share in a single calendar quarter, to $6.16 per share. That's a very "Fifth Street" kind of quarter.

This quarter, Oaktree Specialty Lending's board of directors took an ax to the investment portfolio. Next quarter, the dividend is a likely victim. Many questions also remain unanswered about what Oaktree has in store for this BDC.

Meet the new quarterback

This was an important reporting period for Oaktree Specialty Lending because its new board of directors was responsible for valuing the portfolio, taking the responsibility from Fifth Street Asset Management's previously appointed yes-men.

The new board of directors has little vested interest in preserving the reputation of the old board of directors. This much was apparent from the fact that it slashed the marks on many of Oaktree Specialty Lending's investments, taking particular aim at its controlled companies, investments in which the manager has more latitude in determining fair values that are reported in its quarterly filings.

The largest impairments to controlled company valuations appear in the table below. (In all, controlled companies declined in value by about $84 million on a net basis, as some smaller gains and losses that aren't reflected in the table roughly netted out.)

Data source: SEC filings. Calculations by author.

As many BDCs will say, valuation is more art than science. Changing a few inputs can result in a substantially different output. But many of the writedowns were related to assets that were already impaired, suggesting that the outlook may have worsened for many of Oaktree Specialty Lending's portfolio companies.

Astonishingly, 16.4% of the debt portfolio at cost is now on nonaccrual, meaning the company is no longer recognizing income from these investments. On average, nonaccrual investments are valued at about 29% of their amortized cost, and many could be complete and total losses over time.

Image source: Getty Images.

Can Oaktree turn things around?

Many people view Oaktree as the Tom Brady of the debt investing world, and it may very well be. But if the manager is Brady, the assets underlying Oaktree Specialty Lending are the Cleveland Browns. Winners are few and far between, and many of its historical winners (like its equity investment in cooler company Yeti) are depreciating faster than a 40-year old quarterback.

But just as Brady plays American football, not soccer, Oaktree is known for distressed debt, not direct lending. BDCs typically deal in direct loans, providing capital to small businesses and private equity-backed companies at single-digit discounts to par value, not snapping up problem credits for pennies on the dollar as a distressed debt investor does.

By all appearances, Oaktree Specialty Lending aims to be a run-of-the-mill BDC, not a distressed debt specialist. This became evident when, on the conference call, the new management team talked about a potential investment that would yield LIBOR + 8%, which is about as average as it gets for a BDC. 

Image source: Author, data from SEC filings.

If management's talk about the potential investment is a hint about what Oaktree Specialty Lending will invest in, I suspect investors who are just getting used to a $0.125 quarterly dividend will be disappointed with its future dividend policy.

Management said that it expects "dividend payments will vary from quarter-to-quarter until the portfolio is stabilized." In the long term, it anticipates paying a consistent dividend as it rotates the portfolio into Oaktree-selected credits. Investors should be most interested in its steady-state earnings power after the portfolio is completely reworked and reinvested by Oaktree.

In my view, the best case is that the company generates about $0.10 a share in quarterly earnings from a plain-vanilla debt portfolio. And by best case, I mean best case. More likely, Oaktree Specialty Lending could afford to pay out approximately $0.08 a share per quarter based on my model, which gives it some wiggle room for future credit losses while buying it some time to work out the problem credits and redeploy the proceeds into its own brand of investments. In either case, though, I'm assuming this quarter's outsize losses were a one-off event. No company can lose dollars to credit losses while earning pennies in recurring income.

More questions than answers

There are a lot of question marks surrounding Oaktree's foray into the BDC industry. But perhaps the biggest of them all is why Oaktree decided to buy the management contracts of the Fifth Street entities in the first place. 

There isn't a credit investor on earth who has never heard of Oaktree. Howard Marks' firm is legendary in the distressed debt world, and his frequent writings have become the debt investor's bible. But Oaktree apparently saw something in Fifth Street, as it paid a very high price to run two of the most troubled BDCs on the market, roughly $320 million in all. 

In the pitch to Fifth Street Finance's shareholders, Oaktree said the BDCs could benefit from being part of the Oaktree platform when it was folded into the direct lending strategy. It's a relatively new business line for Oaktree, which started making private loans in 2012. Its U.S. private debt funds had all of $922 million of net assets under management at the end of the most recent quarter. Even after taking an ax to the portfolio, Oaktree Specialty Lending (which wasn't included in the $922 million figure) had a net asset value of approximately $877 million. The deal to manage Fifth Street's funds more than doubled its footprint when Oaktree Strategic Income (OCSI) is included.

Assets are just one way to measure the size of an investment firm. Head count is another. It's notable to me that of the 11 nonexecutive investment professionals listed on Oaktree Specialty Lending website, three are ex-Fifth Street Asset Management employees. Together with two other Oaktree employees, they form the five-member group that operates out of a New York office. There is a lot of Fifth Street in these Oaktree-branded BDCs.

Oaktree brings a lot of credibility and cache, but direct lending is a pretty new ballgame for one of Wall Street's most respected distressed debt shops. A friendly name isn't a reason for investors to let their guard down.