Oaktree Specialty Lending (US:OCSL)2021-02-03 23:15PART I — FINANCIAL INFORMATION This section provides the unaudited consolidated financial statements and management's discussion and analysis for Oaktree Specialty Lending Corporation Item 1. Consolidated Financial Statements This section presents the unaudited consolidated financial statements, including statements of assets, operations, cash flows, and detailed investment schedules Consolidated Statements of Assets and Liabilities Total assets and net assets significantly increased as of December 31, 2020, primarily due to higher total investments at fair value | Metric | December 31, 2020 (in thousands) | September 30, 2020 (in thousands) | | :----------------------------------- | :--------------------------------- | :--------------------------------- | | Total investments at fair value | $1,712,324 | $1,573,851 | | Cash and cash equivalents | $24,234 | $39,096 | | Total assets | $1,793,903 | $1,640,712 | | Total liabilities | $828,986 | $725,833 | | Total net assets | $964,917 | $914,879 | | Net asset value per common share | $6.85 | $6.49 | Consolidated Statements of Operations Net investment income and net assets from operations increased substantially for Q4 2020, driven by higher investment income and significant net unrealized appreciation | Metric | Three months ended Dec 31, 2020 (in thousands) | Three months ended Dec 31, 2019 (in thousands) | | :------------------------------------------- | :--------------------------------------------- | :--------------------------------------------- | | Total investment income | $38,204 | $30,960 | | Total expenses | $28,186 | $17,924 | | Net investment income | $10,018 | $7,836 | | Net unrealized appreciation (depreciation) | $47,556 | $2,879 | | Net realized gains (losses) | $8,215 | $3,288 | | Net increase (decrease) in net assets from operations | $65,544 | $13,843 | | Earnings per common share | $0.46 | $0.10 | Consolidated Statements of Changes in Net Assets Net assets increased significantly in Q4 2020, primarily due to strong operational performance, including net investment income and substantial net unrealized appreciation, despite distributions to stockholders | Metric | Three months ended Dec 31, 2020 (in thousands) | Three months ended Dec 31, 2019 (in thousands) | | :------------------------------------------------- | :--------------------------------------------- | :--------------------------------------------- | | Net assets at beginning of period | $914,879 | $930,630 | | Net increase (decrease) in net assets from operations | $65,544 | $13,843 | | Distributions to stockholders | $(15,506) | $(13,391) | | Total increase (decrease) in net assets | $50,038 | $452 | | Net assets at end of period | $964,917 | $931,082 | Consolidated Statements of Cash Flows Cash and cash equivalents decreased in Q4 2020 due to significant cash used in financing activities, partially offset by cash provided by operating activities | Metric | Three months ended Dec 31, 2020 (in thousands) | Three months ended Dec 31, 2019 (in thousands) | | :------------------------------------------- | :--------------------------------------------- | :--------------------------------------------- | | Net cash provided by (used in) operating activities | $16,072 | $(43,469) | | Net cash provided by (used in) financing activities | $(30,594) | $49,589 | | Net increase (decrease) in cash and cash equivalents | $(14,862) | $6,121 | | Cash and cash equivalents, end of period | $24,234 | $21,527 | Consolidated Schedule of Investments (December 31, 2020) The investment portfolio totaled $1.71 billion across 115 companies, with 85.7% in senior secured debt, showing an increase from the prior quarter | Investment Type | Cost (in thousands) | Fair Value (in thousands) | % of Net Assets | | :--------------------------------- | :------------------ | :------------------------ | :-------------- | | Control Investments | $243,990 | $207,760 | 21.5% | | Affiliate Investments | $10,303 | $8,971 | 0.9% | | Non-Control/Non-Affiliate Investments | $1,503,368 | $1,495,593 | 155.0% | | Total Portfolio Investments | $1,757,661 | $1,712,324 | 177.5% | | Cash and Cash Equivalents | $24,234 | $24,234 | 2.5% | - As of December 31, 2020, 85.7% of the Company's portfolio at fair value consisted of senior secured debt investments and 8.7% consisted of subordinated debt investments106 - The portfolio included 115 portfolio companies, with $125.5 million invested in Senior Loan Fund JV I, LLC (SLF JV I)106 Consolidated Schedule of Investments (September 30, 2020) The investment portfolio totaled $1.57 billion across 113 companies, with 84.1% in senior secured debt, providing a comparative baseline | Investment Type | Cost (in thousands) | Fair Value (in thousands) | % of Net Assets | | :--------------------------------- | :------------------ | :------------------------ | :-------------- | | Control Investments | $245,950 | $201,385 | 22.0% | | Affiliate Investments | $7,551 | $6,509 | 0.7% | | Non-Control/Non-Affiliate Investments | $1,415,669 | $1,365,957 | 149.3% | | Total Portfolio Investments | $1,669,170 | $1,573,851 | 172.0% | | Cash and Cash Equivalents | $39,096 | $39,096 | 4.3% | - As of September 30, 2020, 84.1% of the Company's portfolio at fair value consisted of senior secured debt investments and 10.3% consisted of subordinated debt investments106 - The portfolio included 113 portfolio investments, with $117.4 million invested in Senior Loan Fund JV I, LLC (SLF JV I)106 Notes to Consolidated Financial Statements Detailed explanations of financial reporting, including organization, accounting policies, investment valuation, and significant events like the pending merger Note 1. Organization Oaktree Specialty Lending Corporation is a BDC and RIC focused on flexible financing solutions, externally managed by Oaktree, with a pending merger - Oaktree Specialty Lending Corporation is a closed-end, externally managed, non-diversified management investment company regulated as a Business Development Company (BDC) and has elected to be treated as a Regulated Investment Company (RIC) for tax purposes65 - The company's investment objective is to generate current income and capital appreciation by providing flexible financing solutions, including first and second lien loans, unsecured and mezzanine loans, bonds, preferred equity, and certain equity co-investments66 - The company is externally managed by Oaktree Fund Advisors, LLC, a subsidiary of Oaktree Capital Group, LLC, and an administration agreement is in place with Oaktree Fund Administration, LLC67 - An Agreement and Plan of Merger with Oaktree Strategic Income Corporation (OCSI) was entered into on October 28, 2020, with OCSI merging into the Company, subject to conditions68 Note 2. Significant Accounting Policies Financial statements adhere to GAAP and ASC 946, with key policies covering fair value measurements, foreign currency, derivatives, and revenue recognition - Financial statements are prepared in accordance with GAAP and ASC Topic 946, Financial Services - Investment Companies69 - Investments are valued at fair value in accordance with ASC 820, using a three-level hierarchy (Level 1: quoted prices in active markets; Level 2: observable inputs other than Level 1; Level 3: unobservable inputs)7479 - Revenue recognition policies cover interest income (accrued with OID accretion), PIK interest (accrued if collectible), fee income (recognized upon closing or as earned), and dividend income (recognized on ex-dividend or record date)90929395 - The company has elected to be taxed as a RIC, requiring distribution of at least 90% of taxable income. Taxable subsidiaries are consolidated for financial reporting but not for U.S. federal income tax, leading to deferred tax assets and liabilities102103 Note 3. Portfolio Investments The portfolio comprises $1.7 billion in 115 companies, with 85.7% in senior secured debt, detailed by fair value hierarchy and SLF JV I summary - As of December 31, 2020, 177.5% of net assets ($1.7 billion) was invested in 115 portfolio companies, including $125.5 million in SLF JV I. Senior secured debt constituted 85.7% of the portfolio at fair value106 Investment Composition by Type (Fair Value) | Investment Type | Dec 31, 2020 (in thousands) | Sep 30, 2020 (in thousands) | | :--------------------------------- | :-------------------------- | :-------------------------- | | Investments in debt securities | $1,520,243 | $1,388,605 | | Investments in equity securities | $66,567 | $67,806 | | Debt investment in SLF JV I | $96,250 | $96,250 | | Equity investment in SLF JV I | $29,264 | $21,190 | | Total | $1,712,324 | $1,573,851 | Fair Value Hierarchy of Investments (December 31, 2020) | Asset Type | Level 1 (in thousands) | Level 2 (in thousands) | Level 3 (in thousands) | Net Asset Value (in thousands) | Total (in thousands) | | :-------------------------------------------------------------------------------- | :--------------------- | :--------------------- | :--------------------- | :----------------------------- | :------------------- | | Investments in debt securities (senior secured) | $— | $389,161 | $1,078,416 | $— | $1,467,577 | | Investments in debt securities (subordinated, including the debt investment in SLF JV I) | $— | $34,744 | $114,172 | $— | $148,916 | | Investments in equity securities (preferred) | $— | $— | $29,731 | $— | $29,731 | | Investments in equity securities (common and warrants, including LLC equity interests of SLF JV I) | $— | $— | $35,472 | $30,628 | $66,100 | | Total investments at fair value | $— | $423,905 | $1,257,791 | $30,628 | $1,712,324 | - SLF JV I, a joint venture with Kemper, had total assets of $341.2 million as of December 31, 2020, primarily consisting of senior secured loans to 56 portfolio companies. The company's investment in SLF JV I was $125.5 million at fair value137 Note 4. Fee Income Total fee income for Q4 2020 was $3.4 million, with $0.1 million being recurring, a significant increase from $1.1 million in the same period of 2019 Total Fee Income | Period | Total Fee Income (in thousands) | Recurring Fee Income (in thousands) | | :--------------------------------- | :------------------------------ | :---------------------------------- | | Three months ended Dec 31, 2020 | $3,400 | $100 | | Three months ended Dec 31, 2019 | $1,100 | $200 | Note 5. Share Data and Net Assets Earnings per share increased significantly to $0.46 for Q4 2020, reflecting strong operational performance and net asset growth to $964.9 million Earnings Per Common Share | Metric | Three months ended Dec 31, 2020 | Three months ended Dec 31, 2019 | | :--------------------------------------- | :------------------------------ | :------------------------------ | | Earnings (loss) per common share | $0.46 | $0.10 | | Weighted average common shares outstanding | 140,961 | 140,961 | Changes in Net Assets (December 31, 2020) | Item | Shares (in thousands) | Par Value (in thousands) | Additional paid-in-capital (in thousands) | Accumulated Overdistributed Earnings (in thousands) | Total Net Assets (in thousands) | | :--------------------------------------- | :-------------------- | :----------------------- | :---------------------------------------- | :---------------------------------- | :------------------------------ | | Balance as of September 30, 2020 | 140,961 | $1,409 | $1,487,774 | $(574,304) | $914,879 | | Net increase in net assets from operations | — | — | — | $65,544 | $65,544 | | Distributions to stockholders | — | — | — | $(15,506) | $(15,506) | | Balance as of December 31, 2020 | 140,961 | $1,409 | $1,487,774 | $(524,266) | $964,917 | - The company has a dividend reinvestment plan (DRIP) where distributions are automatically reinvested in additional shares unless a stockholder elects to receive cash. Shares are issued at the greater of NAV or 95% of market price if trading at a premium, or purchased in the open market if trading at a discount165 Note 6. Borrowings Borrowings include a senior secured revolving Credit Facility, which was increased to $800 million as of December 31, 2020, and $300 million in 3.500% unsecured notes due 2025, with previous notes fully redeemed - The Credit Facility was increased to $800 million as of December 31, 2020, with a drawing period expiring on February 25, 2023, and a maturity date of February 25, 2024. The interest rate margin for LIBOR loans is 2.00%170173 Credit Facility Borrowings and Interest Expense | Metric | Dec 31, 2020 (in thousands) | Sep 30, 2020 (in thousands) | 3 months ended Dec 31, 2020 (in thousands) | 3 months ended Dec 31, 2019 (in thousands) | | :--------------------------------- | :-------------------------- | :-------------------------- | :------------------------------------------- | :------------------------------------------- | | Borrowings outstanding | $400,025 | $414,825 | N/A | N/A | | Weighted average interest rate | N/A | N/A | 2.323% | 3.983% | | Interest expense (inclusive of fees) | N/A | N/A | $3,200 | $4,000 | - The company issued $300.0 million in 3.500% unsecured notes due 2025 (2025 Notes) on February 25, 2020. As of December 31, 2020, $300.0 million of these notes were outstanding, with a carrying value of $294.8 million and a fair value of $311.3 million177183 - The 5.875% notes due 2024 (2024 Notes) and 6.125% notes due 2028 (2028 Notes) were fully redeemed on March 2, 2020, and March 13, 2020, respectively185188 Note 7. Interest and Dividend Income Only one investment was on non-accrual status for cash and/or PIK interest or OID income as of December 31, 2020, indicating 99.96% accruing debt investments at cost, an improvement from prior quarter Debt Investments by Accrual Status | Accrual Status | Dec 31, 2020 Cost (in thousands) | Dec 31, 2020 Fair Value (in thousands) | Sep 30, 2020 Cost (in thousands) | Sep 30, 2020 Fair Value (in thousands) | | :--------------- | :------------------------------- | :------------------------------------- | :------------------------------- | :------------------------------------- | | Accrual | $1,609,920 | $1,616,023 | $1,500,364 | $1,483,284 | | PIK non-accrual | — | — | $12,661 | — | | Cash non-accrual | $588 | $470 | $5,712 | $1,571 | | Total | $1,610,508 | $1,616,493 | $1,518,737 | $1,484,855 | - As of December 31, 2020, there was only one investment on which the Company had stopped accruing cash and/or PIK interest or OID income, compared to two investments as of September 30, 2020191 Note 8. Taxable/Distributable Income and Dividend Distributions Taxable income for Q4 2020 was an estimated $13.8 million, an increase from $12.1 million in the prior year, reflecting RIC status and deferred tax assets Reconciliation of Net Assets to Taxable Income | Metric | Three months ended Dec 31, 2020 (in thousands) | Three months ended Dec 31, 2019 (in thousands) | | :------------------------------------------- | :--------------------------------------------- | :--------------------------------------------- | | Net increase (decrease) in net assets from operations | $65,544 | $13,843 | | Net unrealized (appreciation) depreciation | $(47,556) | $(2,879) | | Taxable/Distributable Income (estimate) | $13,767 | $12,109 | - The company had net capital loss carryforwards of $515.3 million as of September 30, 2020, available to offset future capital gains194 - As of December 31, 2020, the company recognized a deferred tax asset of $1.1 million, after determining that $1.8 million of the $2.9 million net deferred tax assets would not likely be realized199 Note 9. Realized Gains or Losses and Net Unrealized Appreciation or Depreciation For Q4 2020, the company recorded a net realized gain of $8.2 million, primarily from PLATO Learning Inc. and L Squared Capital, with net unrealized appreciation of $47.6 million Net Realized Gain (Loss) by Portfolio Company (3 months ended Dec 31, 2020) | Portfolio Company | Net Realized Gain (Loss) (in millions) | | :------------------------ | :------------------------------------- | | PLATO Learning Inc. | $7.8 | | L Squared Capital | $1.4 | | BX Commercial Mortgage Trust 2020-VIVA | $1.2 | | ExamSoft Worldwide Inc. | $0.9 | | California Pizza Kitchen Inc. | $(2.1) | | 99 Cents Only Stores | $(0.9) | | Other, net | $(0.1) | | Total, net | $8.2 | - Net unrealized appreciation for the three months ended December 31, 2020, was $47.6 million, consisting of $27.2 million on debt investments, $12.8 million related to exited investments, and $9.9 million on equity investments, partially offset by $2.4 million depreciation on foreign currency forward contracts206 - For the three months ended December 31, 2019, net realized gains were $3.3 million, primarily from YETI Holdings, Inc., and net unrealized appreciation was $2.9 million204206 Note 10. Concentration of Credit Risks Credit risk is concentrated in cash deposits exceeding FDIC limits, managed by depositing with high-credit-quality financial institutions - The company deposits its cash with financial institutions, and these balances may at times exceed the FDIC insurance limit207 - Credit risk is managed by depositing cash with high credit quality financial institutions and monitoring their financial stability207 Note 11. Related Party Transactions Significant related party transactions include base management fees ($6.5 million for Q4 2020) and incentive fees (Part I: $4.1 million; Part II: $9.5 million for Q4 2020) with Oaktree, plus a $6.0 million base management fee waiver post-merger - As of December 31, 2020, the company had a liability of $20.2 million for unpaid base management and incentive fees payable to Oaktree208 - The base management fee is 1.50% annually of total gross assets (excluding cash and cash equivalents), with a reduced rate of 1.00% for gross assets exceeding 200% of net asset value. Oaktree agreed to waive $750,000 of base management fees for eight quarters post-merger, totaling $6.0 million214 Base Management Fee Incurred | Period | Base Management Fee (in thousands) | | :--------------------------------- | :------------------------------- | | Three months ended Dec 31, 2020 | $6,500 | | Three months ended Dec 31, 2019 | $5,600 | - The incentive fee has two parts: Part I (incentive fee on income) is calculated quarterly based on pre-incentive fee net investment income, subject to a 1.50% hurdle rate and a 'catch-up' provision. Part II (capital gains incentive fee) is 17.5% of cumulative realized capital gains, net of losses and unrealized depreciation, from September 30, 2019216221 Incentive Fees Incurred | Fee Type | Three months ended Dec 31, 2020 (in thousands) | Three months ended Dec 31, 2019 (in thousands) | | :------------------------ | :--------------------------------------------- | :--------------------------------------------- | | Part I incentive fee | $4,100 | $3,000 | | Part II incentive fee | $9,500 | $1,100 | - Oaktree Administrator provides administrative services, for which the company reimburses allocable overhead and expenses at cost. As of December 31, 2020, $2.4 million was due to the affiliate for these expenses232234 Note 12. Financial Highlights Key financial highlights for Q4 2020 show a net asset value per share of $6.85, a total return of 17.34%, an asset coverage ratio of 236.67%, and a debt to equity ratio of 0.73x Key Financial Highlights | Metric | Three months ended Dec 31, 2020 | Three months ended Dec 31, 2019 | | :------------------------------------------- | :------------------------------ | :------------------------------ | | Net asset value per share at end of period | $6.85 | $6.61 | | Total return | 17.34% | 7.23% | | Ratio of net investment income to average net assets | 4.21% | 3.33% | | Ratio of total expenses to average net assets | 11.83% | 7.61% | | Asset coverage ratio at end of period | 236.67% | 271.92% | - The company's debt to equity ratio was 0.73x as of December 31, 2020, with a target range of 0.85x to 1.0x354 Note 13. Derivative Instruments The company uses foreign currency forward contracts to mitigate exchange rate risk, with derivative liabilities of $2.203 million from these contracts as of December 31, 2020 - The company uses foreign currency forward contracts to mitigate the impact of adverse changes in foreign exchange rates on its foreign-denominated investments240 - Derivative instruments are valued at fair value, with unrealized gains or losses recorded in 'net unrealized appreciation (depreciation)' and realized gains or losses in 'net realized gains (losses)' in the Consolidated Statements of Operations242 Foreign Currency Forward Contracts (December 31, 2020) | Description | Notional Amount to be Purchased | Notional Amount to be Sold | Balance Sheet Location of Net Amounts | | :------------------------------ | :------------------------------ | :------------------------- | :------------------------------------ | | Foreign currency forward contract | $36,999 £ | $27,894 | Derivative liability | | Foreign currency forward contract | $30,308 € | $25,614 | Derivative liability | | Total Gross Amount of Recognized Liabilities | N/A | N/A | $2,203 | Note 14. Commitments and Contingencies The company faces merger litigation and has $197.6 million in unfunded commitments as of December 31, 2020, primarily for debt financing to portfolio companies ($192.8 million) - A putative stockholder lawsuit (Merger Litigation) was filed on December 18, 2020, alleging direct and derivative breaches of fiduciary duty by the Board of Directors in connection with the OCSI merger. The company believes these claims are without merit and intends to defend against them246248 - As of December 31, 2020, off-balance sheet arrangements consisted of $197.6 million in unfunded commitments, including $192.8 million for debt financing to portfolio companies, $1.3 million for equity financing to SLF JV I, and $3.5 million for limited partnership interests250 Unfunded Commitments by Investment | Investment | December 31, 2020 (in thousands) | September 30, 2020 (in thousands) | | :--------------------------------- | :------------------------------- | :------------------------------- | | Assembled Brands Capital LLC | $33,326 | $36,079 | | WPEngine, Inc. | $26,348 | $26,348 | | NuStar Logistics, L.P. | $17,911 | $17,911 | | Athenex, Inc. | $17,085 | $22,780 | | FFI Holdings I Corp | $16,529 | — | | Thrasio, LLC | $11,355 | — | | Jazz Acquisition, Inc. | $10,147 | — | | Gulf Operating, LLC | $10,064 | — | | Latam Airlines Group S.A. | $8,177 | — | | MRI Software LLC | $6,473 | $7,239 | | NeuAG, LLC | $4,382 | $4,382 | | Corrona, LLC | $3,968 | $5,189 | | Olaplex, Inc. | $3,834 | $1,917 | | Pingora MSR Opportunity Fund I-A, LP | $3,500 | $3,500 | | Dominion Diagnostics, LLC | $3,449 | $5,887 | | Mindbody, Inc. | $3,048 | $3,048 | | Ardonagh Midco 3 PLC | $2,506 | $3,007 | | Accupac, Inc. | $2,346 | $2,346 | | Acquia Inc. | $2,240 | $2,240 | | New IPT, Inc. | $2,229 | $2,229 | | ADB Companies, LLC | $1,667 | — | | Apptio, Inc. | $1,538 | $1,538 | | Telestream Holdings Corporation | $1,417 | — | | Senior Loan Fund JV I, LLC | $1,328 | $1,328 | | Ministry Brands, LLC | $1,000 | $425 | | Coyote Buyer, LLC | $942 | $942 | | Immucor, Inc. | $541 | $541 | | GKD Index Partners, LLC | $231 | $231 | | A.T. Holdings II SÀRL | — | $7,541 | | iCIMs, Inc. | — | $882 | | Total | $197,581 | $157,530 | Note 15. Pending Merger with OCSI A merger agreement with OCSI was signed on October 28, 2020, where OCSI will merge into the company, with closing anticipated in the first half of 2021 - On October 28, 2020, the company entered into a Merger Agreement with OCSI, where OCSI will merge into the company, with the company continuing as the surviving entity253 - Each share of OCSI common stock will be converted into a number of the company's common shares based on an Exchange Ratio, calculated from the net asset values of both companies prior to the merger254255 - The merger is anticipated to close during the first half of calendar year 2021, contingent on stockholder approvals and other closing conditions258 - The Mergers are expected to be accounted for as an asset acquisition of OCSI by the company, with the fair value of total consideration allocated to acquired assets and assumed liabilities based on their relative fair values260 Note 16. Subsequent Events On January 29, 2021, the Board of Directors declared a quarterly distribution of $0.12 per share, payable in cash on March 31, 2021 - On January 29, 2021, the Board of Directors declared a quarterly distribution of $0.12 per share, payable in cash on March 31, 2021, to stockholders of record on March 15, 2021263 Schedule 12-14: Schedule of Investments in and Advances to Affiliates This schedule details investments in and advances to affiliates, categorizing Control and Affiliate types by fair value, additions, and reductions Control Investments (December 31, 2020) | Portfolio Company | Fair Value as of Oct 1, 2020 (in thousands) | Gross Additions (in thousands) | Gross Reductions (in thousands) | Fair Value as of Dec 31, 2020 (in thousands) | % of Total Net Assets | | :--------------------------------- | :------------------------------------------ | :----------------------------- | :------------------------------ | :------------------------------------------- | :---------------------- | | C5 Technology Holdings, LLC | $27,638 | $— | $— | $27,638 | 2.9% | | Dominion Diagnostics, LLC | $40,587 | $2,439 | $(70) | $45,289 | 4.7% | | First Star Speir Aviation Limited | $13,132 | $2,204 | $(6,155) | $9,181 | 1.0% | | New IPT, Inc. | $2,588 | $33 | $(150) | $2,471 | 0.3% | | Senior Loan Fund JV I, LLC | $117,440 | $8,074 | $— | $125,514 | 13.0% | | Total Control Investments | $201,385 | $12,750 | $(6,375) | $207,760 | 21.5% | Affiliate Investments (December 31, 2020) | Portfolio Company | Fair Value as of Oct 1, 2020 (in thousands) | Gross Additions (in thousands) | Gross Reductions (in thousands) | Fair Value as of Dec 31, 2020 (in thousands) | % of Total Net Assets | | :--------------------------------- | :------------------------------------------ | :----------------------------- | :------------------------------ | :------------------------------------------- | :---------------------- | | Assembled Brands Capital LLC | $5,768 | $2,765 | $(65) | $8,468 | 0.9% | | Caregiver Services, Inc. | $741 | $— | $(238) | $503 | 0.1% | | Total Affiliate Investments | $6,509 | $2,765 | $(303) | $8,971 | 0.9% | - Gross additions include increases in cost basis from new investments, follow-on investments, accrued PIK interest, and exchanges of securities267271 - Gross reductions include decreases from principal payments, sales, and exchanges267271 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations Management discusses financial performance, business strategy, COVID-19 impact, accounting policies, liquidity, capital resources, and significant transactions Business Overview Oaktree Specialty Lending Corporation is a BDC and RIC providing credit solutions to middle-market companies (enterprise values $100 million-$750 million), actively managing its portfolio, with a pending merger - The company is a specialty finance company, BDC, and RIC, externally managed by Oaktree, aiming to generate current income and capital appreciation through flexible financing solutions for middle-market companies (enterprise values $100 million-$750 million)277278279280 - Oaktree is actively rotating the portfolio into 'core investments' and has reduced 'non-core' investments by over $700 million at fair value since October 2017, with approximately $125 million remaining as of December 31, 2020281 - A merger with Oaktree Strategic Income Corporation (OCSI) is anticipated to occur during the first half of calendar year 2021, subject to closing conditions and stockholder approvals282 Business Environment and Developments COVID-19 creates economic uncertainty, but the company sees attractive returns, proactively monitors portfolio companies, and prepares for the LIBOR phase-out by end of 2021 (or June 30, 2023, for most US Dollar LIBOR) - The COVID-19 pandemic continues to cause economic uncertainty, but the company believes attractive risk-adjusted returns can be achieved in the middle market due to Oaktree's investment platform283284 - The company has proactively evaluated and supported its portfolio companies, maintaining close contact to understand liquidity and solvency positions285 - As of December 31, 2020, 88.8% of the debt investment portfolio (at fair value) bore interest at floating rates indexed to LIBOR. A prolonged reduction in interest rates could decrease total investment income, and the company is preparing for the phase-out of LIBOR by the end of 2021 (or June 30, 2023, for most US Dollar LIBOR)286 Critical Accounting Policies Financial statements adhere to GAAP and ASC 946, with critical investment valuation using ASC 820's fair value hierarchy and detailed revenue recognition policies - Financial statements are prepared in accordance with GAAP and ASC Topic 946, Financial Services-Investment Companies287 - Investment valuation follows ASC 820, defining fair value as an orderly transaction price between market participants, prioritizing observable market prices (Level 1, 2) over unobservable inputs (Level 3)288289 - The Board of Directors undertakes a multi-step valuation process quarterly, involving Oaktree's valuation team, management, independent valuation firms, and the Audit Committee, to determine fair value296 - Revenue recognition policies include interest income (accrued if collectible, with OID accretion), PIK interest (accrued if sufficient value), fee income (recognized upon closing or as earned), and dividend income (recognized on ex-dividend or record date, based on portfolio company earnings)300302304306 Portfolio Composition The company's portfolio primarily consists of senior secured debt, with $286.3 million in new commitments originated and $160.7 million in proceeds received from exits and repayments - During the three months ended December 31, 2020, the company originated $286.3 million of investment commitments in 14 new and seven existing portfolio companies and funded $241.5 million of investments308 - During the same period, $160.7 million of proceeds were received from prepayments, exits, other paydowns, and sales, with 12 portfolio companies exited308 Portfolio Composition by Investment Type (Fair Value) | Investment Type | December 31, 2020 | September 30, 2020 | | :--------------------------------- | :------------------ | :------------------- | | Senior secured debt | 85.70 % | 84.06 % | | Debt investment in SLF JV I | 5.62 % | 6.12 % | | Subordinated debt | 3.08 % | 4.17 % | | Common equity and warrants | 2.15 % | 2.40 % | | Preferred equity | 1.74 % | 1.90 % | | LLC equity interests of SLF JV I | 1.71 % | 1.35 % | | Total | 100.00 % | 100.00 % | Portfolio Composition by Industry (Fair Value) | Industry | December 31, 2020 | September 30, 2020 | | :--------------------------------- | :------------------ | :------------------- | | Application Software | 12.88 % | 10.21 % | | Multi-Sector Holdings | 7.54 % | 7.74 % | | Data Processing & Outsourced Services | 7.14 % | 6.33 % | | Pharmaceuticals | 6.91 % | 6.55 % | | Biotechnology | 6.54 % | 6.14 % | | Specialized Finance | 4.04 % | 3.08 % | | Health Care Services | 3.64 % | 3.81 % | | Personal Products | 3.27 % | 3.24 % | | Movies & Entertainment | 3.00 % | 2.77 % | | Property & Casualty Insurance | 2.81 % | 2.97 % | Loans and Debt Securities on Non-Accrual Status Only one investment was on cash non-accrual status as of December 31, 2020, representing 0.04% of debt investments at cost and 0.03% at fair value, an improvement from prior quarter Debt Investments by Accrual Status | Accrual Status | Dec 31, 2020 Cost (in thousands) | Dec 31, 2020 Fair Value (in thousands) | Sep 30, 2020 Cost (in thousands) | Sep 30, 2020 Fair Value (in thousands) | | :--------------- | :------------------------------- | :------------------------------------- | :------------------------------- | :------------------------------------- | | Accrual | $1,609,920 | $1,616,023 | $1,500,364 | $1,483,284 | | PIK non-accrual | — | — | $12,661 | — | | Cash non-accrual | $588 | $470 | $5,712 | $1,571 | | Total | $1,610,508 | $1,616,493 | $1,518,737 | $1,484,855 | - As of December 31, 2020, there was one investment on which the company had stopped accruing cash and/or PIK interest or OID income, compared to two investments as of September 30, 2020313 Senior Loan Fund JV I, LLC SLF JV I, a joint venture with Kemper, had total assets of $341.2 million as of December 31, 2020, with the company's investment at $125.5 million, and saw net income increase to $9.2 million from $2.5 million - SLF JV I, a joint venture with Kemper, had total assets of $341.2 million as of December 31, 2020, primarily consisting of senior secured loans to 56 portfolio companies319 - The company's investment in SLF JV I was $125.5 million at fair value as of December 31, 2020, comprising LLC equity interests and SLF JV I Notes319 SLF JV I Selected Statements of Operations Information | Metric | Three months ended Dec 31, 2020 (in thousands) | Three months ended Dec 31, 2019 (in thousands) | | :------------------------------------------- | :--------------------------------------------- | :--------------------------------------------- | | Interest income | $4,475 | $5,393 | | Total investment income | $4,529 | $5,399 | | Total expenses | $3,643 | $4,708 | | Net unrealized appreciation (depreciation) | $8,486 | $2,941 | | Net realized gains (losses) | $(144) | $(1,152) | | Net income (loss) | $9,228 | $2,480 | - SLF JV I's interest expense for the three months ended December 31, 2020, included $1.6 million related to the Deutsche Bank I Facility and $2.0 million related to the SLF JV I Notes341 Discussion and Analysis of Results and Operations Total investment income increased by 23.4% to $38.2 million, driving a 27.8% rise in net investment income to $10.0 million and substantial net unrealized appreciation of $47.6 million Comparison of Key Financial Metrics (3 months ended Dec 31, 2020 vs 2019) | Metric | Dec 31, 2020 (in thousands) | Dec 31, 2019 (in thousands) | Change (in thousands) | % Change | | :------------------------------------------- | :-------------------------- | :-------------------------- | :-------------------- | :------- | | Total Investment Income | $38,204 | $30,960 | $7,244 | 23.4% | | Net Expenses | $28,186 | $23,124 | $5,062 | 21.9% | | Net Investment Income | $10,018 | $7,836 | $2,182 | 27.8% | | Net Realized Gains (Losses) | $8,215 | $3,288 | $4,927 | 150.0% | | Net Unrealized Appreciation (Depreciation) | $47,556 | $2,879 | $44,677 | 1551.8% | - The increase in total investment income was primarily due to a $5.2 million increase in interest income from a larger investment portfolio and a $2.3 million increase in fee income from higher prepayment fees345 - The increase in net expenses was mainly due to a $3.3 million increase in Part II incentive fees, a $1.2 million increase in Part I incentive fees, and a $0.9 million increase in management fees, partially offset by a $0.4 million decrease in interest expense due to lower LIBOR346 Financial Condition, Liquidity and Capital Resources The company targets a debt to equity ratio of 0.85x to 1.0x, with current ratios at 0.73x and 236.7% asset coverage, maintaining sufficient liquidity with $400.0 million undrawn on the Credit Facility - The company expects to fund portfolio growth through additional debt and equity capital, with a target debt to equity ratio of 0.85x to 1.0x352354 - As of December 31, 2020, the company had $702.2 million in senior securities, an asset coverage ratio of 236.7%, and a debt to equity ratio of 0.73x354 - For the three months ended December 31, 2020, there was a net decrease in cash and cash equivalents of $14.9 million, with $16.1 million net cash from operating activities and $30.6 million net cash used in financing activities355 - As of December 31, 2020, the company had $24.2 million in cash and cash equivalents, $400.0 million of undrawn capacity on the Credit Facility, and $197.6 million of unfunded commitments, indicating sufficient liquidity357 Significant Capital Transactions A quarterly distribution of $0.11 per share was paid on December 31, 2020, totaling $15.0 million in cash and $0.5 million in DRIP shares Distributions Per Share | Date Declared | Record Date | Payment Date | Amount per Share | Cash Distribution (in millions) | DRIP Shares Issued | DRIP Shares Value (in millions) | | :---------------- | :------------ | :------------- | :--------------- | :------------------------------ | :----------------- | :------------------------------ | | November 13, 2020 | December 15, 2020 | December 31, 2020 | $0.11 | $15.0 | 93,964 | $0.5 | | November 12, 2019 | December 13, 2019 | December 31, 2019 | $0.095 | $12.9 | 87,747 | $0.5 | Indebtedness As of December 31, 2020, the company had $400.0 million outstanding under its $800 million Credit Facility and $300.0 million in 3.500% unsecured notes due 2025 - As of December 31, 2020, the Credit Facility had $400.0 million of borrowings outstanding, with an interest rate margin of 2.00% over LIBOR365362 Credit Facility Financial Covenants (December 31, 2020) | Financial Covenant | Target Value | September 30, 2020 Reported Value | | :------------------------- | :----------- | :-------------------------------- | | Minimum shareholders' equity | $550 million | $915 million | | Asset coverage ratio | 1.50:1 | 2.27:1 | | Interest coverage ratio | 2.25:1 | 3.69:1 | | Minimum net worth | $500 million | $911 million | - The company had $300.0 million of 3.500% unsecured notes due 2025 outstanding as of December 31, 2020, with a carrying value of $294.8 million and a fair value of $311.3 million367368 - The 5.875% notes due 2024 and 6.125% notes due 2028 were fully redeemed in March 2020369370 Off-Balance Sheet Arrangements As of December 31, 2020, the company's off-balance sheet arrangements totaled $197.6 million in unfunded commitments, primarily for debt financing to portfolio companies ($192.8 million), subject to covenants - As of December 31, 2020, off-balance sheet arrangements consisted of $197.6 million of unfunded commitments371 - These commitments included $192.8 million to provide debt financing to portfolio companies, $1.3 million for equity financing to SLF JV I, and $3.5 million for limited partnership interests371 - Such commitments are subject to portfolio companies' satisfaction of certain financial and nonfinancial covenants and may involve credit risk371 Contractual Obligations As of December 31, 2020, the company's total contractual obligations for principal and interest on its Credit Facility and 2025 Notes amounted to $771.2 million, with the majority ($713.5 million) due in 3-5 years Contractual Obligations by Period (December 31, 2020) | Contractual Obligations | Total (in thousands) | Less than 1 year (in thousands) | 1-3 years (in thousands) | 3-5 years (in thousands) | More than 5 years (in thousands) | | :------------------------ | :------------------- | :------------------------------ | :----------------------- | :----------------------- | :------------------------------- | | Credit Facility | $400,025 | $— | $— | $400,025 | $— | | Interest due on Credit Facility | $27,570 | $8,751 | $17,501 | $1,318 | $— | | 2025 Notes | $300,000 | $— | $— | $300,000 | $— | | Interest due on 2025 Notes | $43,640 | $10,500 | $21,000 | $12,140 | $— | | Total | $771,235 | $19,251 | $38,501 | $713,483 | $— | Regulated Investment Company Status and Distributions The company maintains its RIC status by distributing at least 90% of its annual taxable income, avoiding federal income tax on distributed amounts, and offers a dividend reinvestment plan - The company has qualified and elected to be treated as a RIC, requiring it to distribute at least 90% of its investment company taxable income to avoid federal income tax on distributed amounts377379 - The company did not incur a U.S. federal excise tax for calendar years 2019 and 2020379 - The DRIP allows stockholders to reinvest cash distributions in additional common stock. If shares trade at a premium to NAV, new shares are issued at the greater of NAV or 95% of market price; if at a discount, shares are purchased in the open market384 Qualified Net Interest Income and Short-Term Capital Gains (Year Ended Sep 30, 2020) | Year Ended | Qualified Net Interest Income | Qualified Short-Term Capital Gains | | :----------- | :---------------------------- | :--------------------------------- | | Sep 30, 2020 | 83.4 % | — | Related Party Transactions The company engages in related party transactions with Oaktree Fund Advisors, LLC (investment adviser) and Oaktree Fund Administration, LLC (administrator), as detailed in Note 11 - The company has entered into an Investment Advisory Agreement with Oaktree and an Administration Agreement with Oaktree Administrator, both affiliates of Oaktree385 - Mr. John B. Frank, an interested member of the Board of Directors, has an indirect pecuniary interest in Oaktree385 Recent Developments An amended registration statement for the OCSI merger was filed on January 19, 2021, and declared effective on January 21, 2021, with stockholder meetings scheduled for March 15, 2021 - An amended registration statement on Form N-14, including a joint proxy statement/prospectus for the OCSI merger, was filed on January 19, 2021, and declared effective on January 21, 2021386 - Stockholder meetings for both the company and OCSI are scheduled for March 15, 2021, to vote on merger-related proposals386 - On January 29, 2021, the Board of Directors declared a quarterly distribution of $0.12 per share, payable on March 31, 2021387 Item 3. Quantitative and Qualitative Disclosures about Market Risk The company is exposed to valuation risk for illiquid investments and interest rate risk, as 88.8% of its debt investment portfolio bears floating interest rates, with a 250 basis point increase resulting in an estimated $19.1 million net increase in net assets - The company is subject to valuation risk for investments without readily available market prices, which are valued at fair value by the Board of Directors with management judgment390 - Interest rate risk is significant, as 88.8% of the debt investment portfolio (at fair value) bore floating interest rates as of December 31, 2020391392 Hypothetical Impact of Interest Rate Changes on Net Assets (December 31, 2020) | Basis point increase | Increase in Interest Income (in thousands) | (Increase) in Interest Expense (in thousands) | Net increase (decrease) in net assets from operations (in thousands) | | :------------------- | :----------------------------------------- | :-------------------------------------------- | :----------------------------------------------------------------- | | 250 | $29,066 | $(10,001) | $19,065 | | 200 | $21,838 | $(8,001) | $13,837 | | 150 | $14,610 | $(6,000) | $8,610 | | 100 | $7,471 | $(4,000) | $3,471 | | 50 | $2,703 | $(2,000) | $703 | - The net effect of any decrease in interest rates is limited due to interest rate floors on investments and outstanding borrowings393 Item 4. Controls and Procedures Disclosure controls and procedures were effective as of December 31, 2020, with no material changes to internal control over financial reporting - Management, with the participation of the CEO and CFO, evaluated the effectiveness of disclosure controls and procedures as of December 31, 2020, and concluded they were effective at the reasonable assurance level395 - There were no changes in internal control over financial reporting during the three months ended December 31, 2020, that materially affected or are reasonably likely to materially affect internal control over financial reporting396 PART II — OTHER INFORMATION This section covers legal proceedings, risk factors, equity sales, defaults, mine safety, other information, exhibits, and signatures Item 1. Legal Proceedings The company is a nominal defendant in the 'Merger Litigation' lawsuit, filed on December 18, 2020, alleging fiduciary duty breaches related to the OCSI merger, which it intends to defend - A putative stockholder lawsuit, 'Merger Litigation,' was filed on December 18, 2020, alleging direct and derivative breaches of fiduciary duty against the Board of Directors in connection with the