OCSL

Business Context and Reporting Period

Oaktree Specialty Lending Corp (formerly Fifth Street Finance Corp) is a closed-end, externally managed business development company (BDC) regulated under the 1940 Act and taxed as a Regulated Investment Company (RIC). The reporting period covers the three months ended December 31, 2017. A significant corporate development occurred on October 17, 2017, when Oaktree Capital Management, L.P. became the new Investment Adviser, replacing Fifth Street Management LLC. The company focuses on providing flexible financing solutions, including first and second lien loans, mezzanine loans, and preferred equity, primarily to middle-market companies.

Key Financial Metrics

Material Changes vs. Prior Period

• Revenue Decline: Total investment income decreased by $17.9 million (34.6%) year-over-year, driven primarily by a $14.9 million decrease in interest income due to a smaller portfolio size and a $2.5 million decrease in fee income.
• Expense Reduction: Net expenses decreased by $7.9 million (27.8%) compared to the prior year. This was due to a $3.0 million reduction in base management fees (partially due to the new fee structure with Oaktree), a $3.3 million decrease in incentive fees, and a $3.6 million decrease in interest expense from lower debt levels.
• Improved Net Loss: The net decrease in net assets resulting from operations improved significantly from $(74.2) million in Q4 2016 to $(30.4) million in Q4 2017. This improvement was largely due to a reduction in net unrealized depreciation, which fell from $74.4 million to $43.5 million.
• Portfolio Composition: The portfolio fair value decreased from $1.54 billion to $1.42 billion. Senior secured debt comprised 75.8% of the portfolio at fair value. The company originated $183.0 million in new commitments and funded $200.2 million during the quarter.

Guidance, Outlook, and Risks

• Management Commentary: Oaktree intends to reposition the portfolio to align with its credit investing approach, targeting middle-market companies with enterprise values between $100 million and $750 million. The target portfolio mix is approximately 40-60% first lien loans, 35-55% second lien loans, 5-15% unsecured loans, and 0-10% preferred equity. Management plans to rotate out of approximately $80 million of investments with spreads under 4.0% over LIBOR.
• Outlook: The company expects to generate attractive risk-adjusted returns by investing in companies with limited access to traditional capital markets. The weighted average annual yield on the portfolio was 9.0% as of December 31, 2017.
• Risks and Contingencies:
  • SEC Investigation: The company is cooperating with an SEC Division of Enforcement investigation regarding the activities of its former adviser (Fifth Street), including portfolio valuations and expense allocations. The current Investment Adviser (Oaktree) is not subject to these subpoenas.
  • Credit Risk: As of December 31, 2017, eight investments were on cash or PIK non-accrual status, representing 13.65% of the debt portfolio at cost. Notable non-accrual investments include Ameritox Ltd., Maverick Healthcare Group, and TransTrade Operators.
  • Liquidity: The company has $98.7 million in unfunded commitments. It maintains a $600 million revolving credit facility (ING Facility) with $205 million outstanding as of period end.

Key Facts for Investor Verification

• Investment Adviser Transition: Verify the impact of the October 2017 transition from Fifth Street to Oaktree on fee structures, portfolio strategy, and future performance.
• Non-Accrual Assets: Review the status and potential recovery value of the eight investments on non-accrual status, which represent a significant portion of the debt portfolio cost basis.
• SEC Investigation Status: Monitor updates regarding the SEC investigation into the former adviser to assess potential financial or reputational impacts.
• Debt Maturities: Note the maturity of the $250 million 2019 Notes in March 2019 and the company's ability to refinance or repay this obligation.
• Dividend Sustainability: Assess the ability to maintain the quarterly distribution of $0.125 per share given the decline in net investment income and the reliance on accumulated undistributed income.