Oaktree Specialty Lending (OCSL) - 2020 Q4 - Annual Report

Part I Business Oaktree Specialty Lending Corporation (OCSL) is a specialty finance company regulated as a Business Development Company (BDC) and a Regulated Investment Company (RIC), externally managed by Oaktree Fund Advisors, LLC, aiming to generate current income and capital appreciation by providing customized credit solutions to middle-market companies, with its portfolio valued at $1.6 billion as of September 30, 2020 - The company's investment objective is to generate current income and capital appreciation through flexible financing solutions, including first and second lien loans, unsecured loans, and equity co-investments, primarily for middle-market companies[14] Portfolio Snapshot as of September 30, 2020 | Metric | Value | | :--- | :--- | | Total Portfolio Fair Value (USD) | $1.6 billion | | Number of Portfolio Companies | 113 | | Debt Investments (%) | 94.3% | | Senior Secured Loans (%) | 84.1% | | Weighted Avg. Annual Yield on Debt (%) | 8.3% | | Debt to Equity Ratio (x) | 0.78x | - The company is externally managed by Oaktree Fund Advisors, LLC, an affiliate of Oaktree Capital Management, L.P. (OCM), which is majority-owned by Brookfield Asset Management Inc[13] - On October 28, 2020, the company entered into a merger agreement with Oaktree Strategic Income Corporation (OCSI), which is expected to result in OCSL as the surviving company[19] Business Strategy and Investment Process The company's business strategy focuses on originating proprietary deals, investing in quality companies with extensive diligence, disciplined portfolio management, and managing risk through loan structures, while its rigorous five-stage investment process ensures selective and disciplined new investments and ongoing risk management - Key business strategies emphasize proprietary deal sourcing, extensive due diligence for quality companies, disciplined portfolio management, and risk mitigation through loan structures, with a focus on rotating out of approximately $128 million in non-core investments as of September 30, 2020[31][36] - The investment process consists of five stages: Source, Screen, Research, Evaluate, and Monitor, ensuring a selective and disciplined approach to new investments and ongoing risk management[38][39][44] Investment Portfolio and SLF JV I The investment portfolio primarily consists of various debt instruments, with 84.1% in secured debt as of September 30, 2020, and includes a key joint venture, Senior Loan Fund JV I (SLF JV I), valued at $117.4 million - The portfolio is a mix of senior secured loans, unitranche loans, second lien loans, mezzanine loans, unsecured loans, and bonds, with 84.1% of the portfolio's fair value in debt investments secured by first or second priority liens as of September 30, 2020[46][47] - The company co-invests with Kemper Corporation through SLF JV I, a joint venture focused on middle-market corporate debt, with OCSL's investment valued at $117.4 million at fair value as of September 30, 2020[49] Investment Advisory and Administration Agreements Oaktree manages the company's operations under an Investment Advisory Agreement, receiving a two-part fee (base management and incentive fees), while Oaktree Administrator provides administrative services for reimbursement at cost Management Fee Structure | Fee Type | Rate/Structure | | :--- | :--- | | Base Management Fee (Annual %) | 1.50% annually on gross assets (excluding cash). Reduced to 1.00% on gross assets exceeding 200% of net asset value | | Incentive Fee (Part I - Income) (%) | 17.5% of pre-incentive fee net investment income, subject to a 1.50% quarterly hurdle rate on net assets with a catch-up provision | | Incentive Fee (Part II - Capital Gains) (%) | 17.5% of cumulative net realized capital gains over cumulative net realized capital losses and unrealized depreciation since fiscal year 2019 | - Oaktree Administrator provides necessary administrative services, including office facilities, bookkeeping, and reporting, for which it is reimbursed by the company at cost[85][87] Regulatory Framework The company operates as a Business Development Company (BDC) and a Regulated Investment Company (RIC), requiring it to invest at least 70% of assets in 'qualifying assets' and maintain a 150% asset coverage ratio, while distributing at least 90% of taxable income annually to avoid corporate-level federal income tax - To qualify as a RIC, the company must meet source-of-income and asset diversification tests and distribute at least 90% of its investment company taxable income annually[100][103] - As a BDC, at least 70% of assets must be 'qualifying assets,' and the company must maintain an asset coverage ratio of at least 150%, allowing it to incur up to $2 of debt for every $1 of equity[112][116] Risk Factors The company faces significant risks, including the adverse effects of the COVID-19 pandemic, interest rate fluctuations, uncertainty in the fair value of illiquid portfolio investments, reliance on the Adviser's key personnel, magnification of losses due to leverage, potential conflicts of interest, regulatory constraints, and risks associated with the pending merger with OCSI - The COVID-19 pandemic poses a significant risk, potentially causing distress in portfolio companies, lack of income, and uncertainty in the value of investments[134][135] - Changes in interest rates and the planned LIBOR phase-out by the end of 2021 could adversely affect the company's cost of capital and net investment income[143][147] - A significant portion of the investment portfolio is valued in good faith by the Board of Directors, leading to uncertainty as to the value of these illiquid investments[150] - The use of leverage magnifies the potential for loss, and regulations governing BDCs and RICs affect the ability to raise additional capital, potentially hindering growth[188][161] - Significant potential conflicts of interest exist, as the Adviser's fee structure may incentivize riskier investments, and investment opportunities may be allocated among multiple Oaktree-managed funds[180] - The pending merger with OCSI carries risks, including the potential failure to realize anticipated benefits, integration challenges, and a potential decline in stock price post-merger[259][262] Unresolved Staff Comments The company reports that it has no unresolved staff comments from the Securities and Exchange Commission - There are no unresolved staff comments[281] Properties The company does not own any real estate or other material physical properties, with its principal executive offices located in Los Angeles, CA, considered suitable for its current business operations - The company does not own any material physical properties and leases its principal executive offices[282] Legal Proceedings As of the report date, the company is not a party to any pending material legal proceedings - The company is not currently a party to any pending material legal proceedings[283] Mine Safety Disclosures This item is not applicable to the company - Not applicable[284] Part II Market for Registrant's Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities The company's common stock trades on the Nasdaq Global Select Market under 'OCSL', with prices ranging from $2.33 to $5.65 per share in FY2020, and quarterly distributions totaling $0.39 per share, while estimated annual expenses borne by stockholders total 8.61% of net assets Quarterly Stock Price and Distribution Data (Fiscal Year 2020) | Quarter | NAV per Share (USD) | High Price (USD) | Low Price (USD) | Distribution per Share (USD) | | :--- | :--- | :--- | :--- | :--- | | Q1 | $6.61 | $5.52 | $5.00 | $0.095 | | Q2 | $5.34 | $5.65 | $2.33 | $0.095 | | Q3 | $6.09 | $4.90 | $3.00 | $0.095 | | Q4 | $6.49 | $5.23 | $4.29 | $0.105 | Estimated Annual Expenses (as a % of net assets) | Expense Category | Percentage (%) | | :--- | :--- | | Base management fees | 2.63% | | Incentive fees | 1.66% | | Interest payments on borrowed funds | 2.58% | | Other expenses | 0.78% | | Acquired fund fees and expenses | 0.96% | | Total annual expenses | 8.61% | - The company did not repurchase any shares of its common stock during the fiscal years ended September 30, 2020 and 2019[296] Selected Financial Data This section provides a five-year summary of the company's key financial data, showing total investment income of $143.1 million and net investment income of $72.0 million for FY2020, with NAV per share at $6.49 and total investments at fair value growing to $1.57 billion Selected Financial Data (Fiscal Years 2018-2020) | (Amounts in thousands, except per share) | FY 2020 | FY 2019 | FY 2018 | | :--- | :--- | :--- | :--- | | Total Investment Income (USD) | $143,133 | $147,702 | $138,722 | | Net Investment Income (USD) | $71,992 | $67,909 | $60,046 | | Net Increase (Decrease) in Net Assets (USD) | $39,224 | $126,160 | $46,762 | | NAV per Common Share (USD) | $6.49 | $6.60 | $6.09 | | Total Investments at Fair Value (USD) | $1,573,851 | $1,438,042 | $1,491,201 | | Total Liabilities (USD) | $725,833 | $550,408 | $693,423 | | Total Net Assets (USD) | $914,879 | $930,630 | $858,035 | Management's Discussion and Analysis of Financial Condition and Results of Operations Management discusses the company's business strategy, the impact of the COVID-19 pandemic, and its financial results, highlighting a 3.1% decrease in total investment income to $143.1 million and a 6.0% increase in net investment income to $72.0 million for fiscal year 2020, alongside portfolio growth to $1.6 billion and sufficient liquidity Results of Operations Comparison (FY 2020 vs. FY 2019) | (Amounts in millions USD) | FY 2020 | FY 2019 | Change (%) | | :--- | :--- | :--- | :--- | | Total Investment Income (USD) | $143.1 | $147.7 | -3.1% | | Net Expenses (USD) | $71.1 | $79.8 | -10.8% | | Net Investment Income (USD) | $72.0 | $67.9 | +6.0% | | Net Realized/Unrealized Losses (USD) | $(34.5) | $59.3 | N/A | - The decrease in total investment income was primarily due to lower interest income from the impact of LIBOR decreases and lower non-recurring OID accretion, partially offset by higher prepayment fees[383] - The decrease in net expenses was mainly driven by lower interest expense resulting from LIBOR decreases and debt refinancing, as well as lower net management and incentive fees[384] - As of September 30, 2020, the company had $39.1 million in cash, $1.6 billion in portfolio investments, and $285.2 million of undrawn capacity on its credit facility, indicating sufficient liquidity[396] - Subsequent to year-end, the company entered a merger agreement with OCSI, increased its credit facility to $775 million, and declared a quarterly dividend of $0.11 per share[429][430][431] Quantitative and Qualitative Disclosures about Market Risk The company is exposed to financial market risks, primarily valuation risk for its illiquid portfolio and interest rate risk for its floating-rate assets and liabilities, with 88.3% of the debt portfolio at fair value bearing floating rates, and a hypothetical 100 basis point increase in interest rates estimated to increase annual net assets from operations by approximately $3.3 million - The company's primary market risks are valuation risk for its illiquid portfolio and interest rate risk for its floating-rate assets and liabilities[442] - As of September 30, 2020, 88.3% of the company's debt portfolio at fair value bore interest at floating rates, making its income sensitive to interest rate changes[445] Annualized Impact of Interest Rate Changes on Net Assets | Basis Point Increase | Net Increase in Net Assets (USD thousands) | | :--- | :--- | | 250 | $17,237 | | 200 | $12,548 | | 150 | $7,860 | | 100 | $3,269 | | 50 | $822 | Financial Statements and Supplementary Data This section contains the company's audited consolidated financial statements for the fiscal year ended September 30, 2020, and the related unqualified opinion reports from Ernst & Young LLP, including the Consolidated Statements of Assets and Liabilities, Operations, Changes in Net Assets, and Cash Flows, along with detailed Schedules of Investments and comprehensive Notes - The independent registered public accounting firm, Ernst & Young LLP, issued an unqualified opinion on the consolidated financial statements and on the effectiveness of the company's internal control over financial reporting as of September 30, 2020[451][457] Key Financial Statement Balances as of September 30, 2020 | Account | Amount (USD thousands) | | :--- | :--- | | Total Investments at Fair Value | $1,573,851 | | Total Assets | $1,640,712 | | Total Liabilities | $725,833 | | Total Net Assets | $914,879 | | Net Increase in Net Assets from Operations (FY 2020) | $39,224 | Changes in and Disagreements with Accountants on Accounting and Financial Disclosure This item is not applicable to the company - Not applicable[738] Controls and Procedures Management, including the CEO and CFO, concluded that the company's disclosure controls and procedures were effective at a reasonable assurance level as of September 30, 2020, with internal controls over financial reporting also assessed as effective and confirmed by Ernst & Young LLP, and no material changes reported during the fourth fiscal quarter - Management concluded that disclosure controls and procedures were effective at a reasonable assurance level as of September 30, 2020[739] - Management assessed internal control over financial reporting as effective as of September 30, 2020, an assessment audited and confirmed by Ernst & Young LLP[742][743] - There were no material changes in internal control over financial reporting during the fourth quarter of fiscal year 2020[744] Other Information The company reported no other information for this item - None[745] Part III Directors, Executive Officers and Corporate Governance The information required for this item is incorporated by reference from the company's definitive Proxy Statement for its 2021 Annual Meeting of Stockholders - Information is incorporated by reference from the 2021 Proxy Statement[747] Executive Compensation The information required for this item is incorporated by reference from the company's definitive Proxy Statement for its 2021 Annual Meeting of Stockholders - Information is incorporated by reference from the 2021 Proxy Statement[748] Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters The information required for this item is incorporated by reference from the company's definitive Proxy Statement for its 2021 Annual Meeting of Stockholders - Information is incorporated by reference from the 2021 Proxy Statement[749] Certain Relationships and Related Transactions, and Director Independence The information required for this item is incorporated by reference from the company's definitive Proxy Statement for its 2021 Annual Meeting of Stockholders - Information is incorporated by reference from the 2021 Proxy Statement[750] Principal Accountant Fees and Services The information required for this item is incorporated by reference from the company's definitive Proxy Statement for its 2021 Annual Meeting of Stockholders - Information is incorporated by reference from the 2021 Proxy Statement[751] Part IV Exhibits, Financial Statement Schedules This section lists the documents filed as part of the Annual Report, including the Consolidated Financial Statements, the financial statement schedule for investments in affiliates, and various exhibits such as the Merger Agreement, corporate governance documents, material contracts, and certifications - The report includes the Consolidated Financial Statements and a schedule of Investments in and Advances to Affiliates[754][755] - Exhibits filed with the report include the Merger Agreement with OCSI, the Investment Advisory Agreement, the Administration Agreement, and indentures for outstanding notes[756]