Blue Owl Capital Corporation - Q4 2023

Transcript

Operator (participant)

Hello, and welcome to the Blue Owl Capital Corp Q4 and Fiscal Year 2023 earnings call and webcast. If anyone should require operator assistance, please press star zero on your telephone keypad. A question and answer session will follow the formal presentation. You may be placed into question queue at any time by pressing star one on your telephone keypad. As a reminder, this conference is being recorded. It's now my pleasure to turn the call over to Dana Sclafani, Head of BDC Investor Relations for Blue Owl. Please go ahead, Dana.

Dana Sclafani (Head of BDC Investor Relations)

Thank you, operator. Good morning, everyone, and welcome to Blue Owl Capital Corporation's fourth quarter earnings call. Joining me this morning are our Chief Executive Officer, Craig Packer, and our Chief Financial Officer and Chief Operating Officer, Jonathan Lamm, as well as Alexis Maged, our Chief Credit Officer, and Logan Nicholson, Portfolio Manager for OBDC. I'd like to remind our listeners that remarks made during today's call may contain forward-looking statements, which are not a guarantee of future performance or results, and involve a number of risks and uncertainties that are outside the company's control. Actual results may differ materially from those in forward-looking statements as a result of a number of factors, including those described in OBDC's filings with the SEC. The Company assumes no obligation to update any forward-looking statements.

Certain information discussed on this call and in our earnings materials, including information related to portfolio companies, was derived from third-party sources and has not been independently verified. The Company makes no such representations or warranties with respect to this information. OBDC's earnings release, 10-K and supplemental earnings presentation are available on the investor relations section of our website at blueowlcapitalcorporation.com. With that, I'll turn the call over to Craig.

Craig Packer (CEO)

Thanks, Dana. Good morning, everyone, and thank you all for joining us today. We are very pleased to report another record quarter of earnings with continued excellent credit performance across the portfolio. Net investment income was 51 cents per share, up 2 cents from last quarter. Our NII increased in each quarter of 2023. We generated new record NII for the fourth consecutive quarter. In total, we earned $1.93 of NII in 2023, up 52 cents or 37% year-over-year. Our strong results throughout the year are the outcome of our emphasis on great credit selection and a proactive approach to liability management. Results also benefited from the higher rate environment and continued strong economic conditions. Based on these results, our board has approved another 2-cent increase in our base dividend to 37 cents per share.

This is our third 2-cent increase since the fourth quarter of 2022. This reflects our strong results to date and incorporates our expectations for the future trajectory of earnings, even in a more normalized rate environment. In addition, for the fourth quarter, our board declared a supplemental dividend of 8 cents. We instituted the supplemental dividend framework in the third quarter of 2022 to allow shareholders to participate in our earnings upside in a predictable manner, and we are pleased to have paid 36 cents per share of supplemental dividends over these last six quarters, while also meaningfully growing net asset value. Going forward, we believe shareholders will continue to benefit from this supplemental dividend framework. Net asset value per share increased to $15.45, up 5 cents from the third quarter.

This represents the highest NAV per share since our inception and the second quarter in a row of record net asset value. As a result of strong earnings and continued NAV growth, we earned a record 13.2% return on equity in the fourth quarter, resulting in an annual ROE of 12.7% for the full year. This is right in line with the expectations we set at our Investor Day in May. Looking at our borrowers' results, we saw continued resilience across our portfolio companies throughout 2023. We came into the year appropriately cautious and prepared for a more challenging economic environment. Over the last 12 months, our borrowers, on average, delivered low to mid-single digit growth in both revenue and EBITDA each quarter.

They were proactive in cutting costs and raising prices where appropriate to combat inflationary pressure and supply chain challenges. These initiatives contributed to the solid performance we saw this year. Further, we believe our borrowers are well positioned coming into 2024. Our largest sectors continue to be software, insurance brokerage, food and beverage, and healthcare, all of which serve diversified and durable end markets. The weighted average EBITDA of our portfolio companies is over $200 million, and we believe this scale provides strategic benefits and operational stability as many of our borrowers remain market leaders within their sectors. Looking forward, while markets are expecting rates to decline, short-term rates remain elevated, and as a result, we remain focused on potential portfolio company challenges.

We believe coverage levels will trough in the first half of 2024 at around 1.5-1.6 times interest coverage. We continue to have a small list of borrowers who we believe may see challenges in the months ahead. Our underwriting and portfolio management teams are closely monitoring these situations, and we believe any challenges ultimately will be manageable across our portfolio as a whole. I would note we had a few borrowers migrate lower in our rating scale, but overall, the names on our watch list remains consistent.... Based on the visibility we have today and the strong positioning of our borrowers, we expect that the vast majority of our portfolio companies will maintain solid coverage metrics and adequate liquidity throughout this period.

While we added one very small position to non-accrual in the quarter for a total of four names, our non-accrual rate remains low at 1.1% of the fair value of the debt portfolio. Overall, our record year in 2023 demonstrates the resilience of our portfolio companies and the strength of our investment and portfolio management process. With that, I'll turn it over to Jonathan to provide more detail on our financial results.

Jonathan Lamm (CFO and COO)

Thanks, Craig. We ended the quarter with total portfolio investments of $12.7 billion, outstanding debt of $7.1 billion, and total net assets of $6 billion. Our fourth quarter NAV per share was $15.45, a 5-cent increase from our third quarter NAV per share of $15.40, attributable to the continued over-earning of our total dividends. In terms of deployment, we continue to largely match originations with repayments to maintain a fully invested portfolio. Repayments increased this quarter to $1.1 billion, which was matched by $1 billion of new investment fundings.

This was a sizable increase compared to the roughly $390 million of repayments we saw in the third quarter, and is consistent with our belief that we will see an increase in repayments as the market environment continues to be more favorable for refinancings. We ended the quarter with net leverage at 1.09 times, down slightly from the prior quarter. This is largely reflective of the timing of repayments versus new originations in the quarter. Turning to the income statement, we earned a record $0.51 per share in the fourth quarter, up from $0.49 per share in the prior quarter. The increase in NII was driven by roughly 1.5-cent quarter-over-quarter increase of accelerated income, driven by a pickup in repayments as well as modest increases in our dividend and interest income.

For the fourth quarter, the $0.08 per share supplemental dividend will be paid on March fifteenth to shareholders of record on March first. Reflecting this supplemental and the previously declared $0.35 regular dividend, shareholders will receive total dividends of $0.43, which equates to an annualized dividend yield of over 11% based on our NAV per share for the fourth quarter. For the full year 2023, we paid a total of $1.59 per share in dividends, an increase of $0.30, or roughly 25% from the prior year. The board also declared a first quarter regular dividend of $0.37, which will be paid on April fifteenth to shareholders of record as of March twenty-ninth. Pro forma for our new increased regular dividend, coverage remains robust at 138%.

We finished the year with $0.30 of spillover income as a result of meaningful over-earning of our dividends, inclusive of our supplemental dividends throughout 2023. Turning to the balance sheet, we continue to proactively manage our liability structure to maximize returns to our shareholders. In the fourth quarter, we increased our revolver capacity to $1.9 billion and continued to maintain a robust liquidity position, which increased to $2.1 billion. This is well in excess of our unfunded commitments to our portfolio companies. In January, we opportunistically raised $600 million in new 5-year unsecured notes. A portion of the proceeds will be used to repay our $400 million unsecured notes that mature in April 2024.

Taken together, these actions will modestly improve our overall cost of unsecured financing and increase our total unsecured debt as a percentage of total debt to 61%. We continue to be very focused on maintaining a well-laddered liability structure and lowering our financing costs. The spread on this new issuance represents one of our tightest spreads to Treasuries. Further, we were able to swap this new issuance at a rate of S plus 212 basis points, which, when taken together with the maturity of the April 2024 notes, is accretive to ROE for our shareholders and attractively priced relative to our current secured financing costs. The BDC bond market continues to deepen and expand with new investors.

We are pleased to see investors' recognition of OBDC's high-quality portfolio and continued performance, which allowed us to drive improved pricing for this issuance, even in a higher rate environment. As we have since inception, we continue to be proactive at addressing our financing needs and continuing to deepen our investor base and improve our liability costs. With that, I'll turn it back to Craig for closing comments.

Craig Packer (CEO)

... Thanks, Jonathan. To close, I wanted to spend a minute on what we're seeing in the market today and what we expect for 2024. We continued to see deal activity pick up in the fourth quarter. As Jonathan noted, we had over $1 billion in both originations and repayments in OBDC. This nearly equates to the total activity we saw in the first three quarters combined. Across our broader Blue Owl direct lending platform, we deployed over $8 billion in the quarter, the highest quarterly level since 2021. We continue to believe the scale of our platform is an advantage for OBDC, as our large origination effort allows us to efficiently match our repayment and deployment activity each quarter in order to maintain a fully invested portfolio and to scale up deployments in quarters where repayment activity is higher.

We closed on several attractive new deals in the fourth quarter, including the billion-dollar-plus financings for PetVet, New Relic, and IFS, Envoy all three of which Blue Owl serves as lead arranger and administrative agent on. We believe our role as administrative agent on these large deals demonstrates the private equity firm's confidence in our platform, and as importantly, positions us to maintain frequent dialogue and to have the greatest influence on credit documentation and terms. Further, we continue to benefit from incumbency across our portfolio, with significant add-on activity for our current borrowers in the quarter. As noted earlier, repayments stepped up materially in the fourth quarter as we saw a more active market for refinancings and company exits. We expect repayment activity to continue to revert to these higher, more normalized levels, which could generate meaningful repayment income for OBDC.

Looking forward, we expect to see increased market activity throughout 2024. We believe there is substantial pent-up desire for private equity firms to return capital to LPs by exiting companies, and increased clarity on the rate environment could drive more activity. That said, to date, activity in the first quarter has been lighter, which is consistent with the typical seasonality we see after many issuers seek to transact before year-end. Reflecting this dynamic, and with strengthening public and private markets, we're seeing some pressure on spreads across new investment opportunities. However, we continue to see larger and larger companies doing direct deals. The credit quality is some of the highest we've seen in our history, and the structures and terms on new deals remain attractive.

Finally, on behalf of the entire OBDC management team, I want to re-reiterate how pleased we are to have delivered another quarter of impressive results. We are grateful to the investment and portfolio management teams, who continue to assess new opportunities, carefully monitor our portfolio companies, the financing team, who continues to optimize our liability structure, and the entire corporate solutions group, who support the company's complex operations. As a result of these efforts, we delivered a total return of more than 40% to shareholders in 2023. We once again delivered record NII and a record high NAV per share, ultimately providing a 12.7% ROE for the year to our shareholders. We're also pleased to be able to raise our regular dividend, which we believe reflects our continued confidence in the portfolio.

We are entering 2024 on strong footing and believe we are well positioned for the year to come. With that, thank you for your time today, and we will now open the line for questions.

Operator (participant)

Thank you. We'll now be conducting a question and answer session. If you'd like to be placed in the question queue, please press star one on your telephone keypad. A confirmation tone will indicate your line is in the question queue. You may press star two if you'd like to remove your question from the queue. For participants using speaker equipment, it may be necessary to pick up your handset before pressing star one. One moment, please, while we pull for questions. Our first question is coming from Brian McKenna, from Citizens JMP. Your line is now live.

Brian McKenna (Director of Equity Research)

Okay, great. Good morning, everyone. So maybe just a question on credit quality to start. You know, the portfolio is clearly in a very strong position today, but could you just provide any details on the one company you added to non-accrual during the quarter? And then is there any update on the other three companies just in terms of resolving these? And then, you know, more broadly, can you talk about the size of your portfolio management team today? How much has related headcount grown over the last couple of years? And then, you know, where is the team spending a lot of their time today, just given the, you know, the low level of non-accruals today?

Craig Packer (CEO)

Morning, Brian. You shoved, like, four questions in there. You're going to have to remind me before I get to the first couple. Look, overall, we continue to be really pleased with the credit portfolio—credit quality of the portfolio. I think it's pretty striking. You know, think back a year ago, rates, rates as high as they were across the space. I think there was a lot of concern about how direct lending credit quality would hold up, and here we are, more than a year into this higher rate cycle, and, you know, we're really happy with credit quality across the board. And I would say the space as overall has also been really strong.

I think it really is a testimony to the quality of the companies that are coming into the direct lending space, which is as high as it's higher than it's ever been. We had a really de minimis position in a company, Ideal Image, that was less than $15 million of exposure in OBDC. We had some really small exposures in several other funds.

... and it was a business backed by a couple private equity firms, you know, that we do a lot of business with, and had you know some operational challenges and just it is in a position where we felt it was you know appropriate to put it on non-accrual. And you know we're working through with the borrower and the sponsors a plan going forward. So it's a credit-specific issue to that business and not reflective of any greater you know credit issues. Beyond that, the other three names, nothing to report. In the case of two of them, well, I guess one of them, we've taken over the business, the other two, you know, we continue to work with the existing sponsors.

You know, I'll just call out one of the names, CIBT, because I think it's interesting. This is a business that's been on non-accrual for us for several years now, was significantly impacted by COVID as a travel-oriented business. And, you know, it's sponsors have worked, you know, really diligently over the last four years to try to rehabilitate the company in light of changing travel patterns and the like, and continue to own the business and support the business. And we and the other lenders and the capital structure are working with them. We continue to have that particular position marked at a very low price. But, you know, we'll see. We're hoping to do better, but, you know, we'll just have to see.

But it really is a testimony to how hard the private equity firms work to avoid giving up the companies, and that's very much central to our model. I think you asked about resources. You know, we have added significantly to our portfolio management and workout resources. Our investment team overall is about 115 people. There's probably about 15 of those 115 that are doing, you know, full-time portfolio management and workout. You know, our approach to workout here is, you know, some have the same approach, some are different. You know, we have our existing underwriting team that stays involved in the credits. Even if they go into workout, they know the company is the best. And we think that connectivity and consistency is very valuable to maximizing recovery.

So beyond our workout team, which is, which is more than enough size, you know, we really use our, our whole team. Other firms have a different approach, a little more accept, you know, push it into the workout group, if you will. So I feel very comfortable that we have the capacity. You know, there was a business, PLI, that we took over during COVID. You know, we've, it's been restructured. We, you know, we own that business today. It's not on non-accrual anymore.

But if you walk through the marks of our, the debt and equity position, you know, what you will see is that position, although we took a realized loss way back in 2020, if you take the combined value of our debt and equity in that company today, it's pretty much on top of what our original basis was in the business when we first made the loan. We haven't realized on that yet, so I'm not, you know, declaring victory, but I think it's headed in the direction where we'll be able to report at some point that we are declaring victory.

And I think it's, again, a testimony to our ability to have a very long time horizon, to take over a business, to work with an existing management team or supplement that with new management team, and to play for long-term value creation. And I think that's, that's core to being the scaled direct lending business that we are. Part of our value proposition is maximizing recovery. I think PLI will be hopefully a great case study when we realize it on our ability to do that. So, Brian, I think I got most of it. And if I missed any, I'll, I'll give you one more shot.

Brian McKenna (Director of Equity Research)

Yeah. No, that's great. Appreciate all that color, and I'll hop back, back into the queue, and congrats on another great quarter.

Craig Packer (CEO)

Thank you.

Operator (participant)

Thank you. Next question is coming from Casey Alexander from Compass Point. Your line is now live.

Casey Alexander (Managing Director and Senior Equity Analyst)

Yeah. Hi, good morning, and thank you for taking my questions. Just again, everything, you know, I understand that Brian's question sounded like 4 because everything is sort of interconnected. Your discussion about somewhat tighter spreads, private equity, refinancings up, private equity want to return money back, and the fact that you guys work in the upper middle market, does that all combine to, you know, what seems like a little bit of a rejuvenation of the broadly syndicated loan market? And is that contributing to some of the tighter spreads that you see in the upper middle market?

Craig Packer (CEO)

Good morning, Casey. I think that's a great way to great word for it, rejuvenation. The bank's willingness to commit to leverage finance deals is completely a function of there being a bid from buyers of loans, primarily CLOs, and CLO creation rebounded towards the end of last year and has been quite healthy this year. And the strengthening of the syndicated markets is giving the banks confidence, you know, to commit to deals, and the market is quite good. And so the banks are willing to commit, distribute, and the pricing in that market can be attractive for certain companies. And so you're seeing, I would say, more normalization of the mix of flows.

You know, the normal market environment is a fully functioning public market and a fully functioning private market. The trend has been decidedly towards private market execution and direct lending execution. That trend has been going on for, you know, since, certainly since the history of our business, and our growth has tracked that trend. But most normal market environments in most of our existence, the public markets have been open and the banks have been willing to finance deals, and the sponsors have been increasingly picking direct. But in this environment, they've got choices, and they're making those choices. And I think that's a healthy market environment... It does contribute to some of the spread compression.

In the first half of last year, the public markets were shut, and so naturally, direct lenders such as ourselves could charge more. And today, public markets are open, and so there's a price check there, and that can contribute to spread compression. You know, to be forthright, I think spread compression is also a function of a really good economy, you know, expectation that rates are going to come down, and just generally health of the markets. But private credit has raised capital. We have capital, other direct lenders have capital, and so there's competition. So we're on the tight end of the range of spreads that we see in direct lending. I think it's kind of trough probably where it is now, but it's on the tighter end of where things are.

So I think that pendulum will swing back and forth. I like to talk about the, the secular and the cyclical. The secular trend is going to continue to be the direct lending. There'll be cyclical periods of time where it skews a little more to the public markets, a little more to, the private markets. Right now, I think it's a, it's a pretty healthy balance. And, and so you're seeing some spread tightening.

Casey Alexander (Managing Director and Senior Equity Analyst)

Okay, thank you. That's very helpful. My follow-on question is, you know, last two quarters, you've raised the base dividend a couple of times. In the face of what is generally a consensus that, as you mentioned, the rates are going to normalize some. So you got rates going one way and your base dividend going the other way. You know, what gives you the confidence that you're going to be able to, you know, maintain and cover that adequately as rates come down? Is it potential growth of the JV or the specialty finance verticals, or is it expanding the leverage ratio somewhat? You've got kind of a modest ratio right now.

But I'm, you know, curious in holistically how you mix all of those things together to make sure that the board has confidence to raise the Base Dividend again.

Craig Packer (CEO)

Sure. So, you know, I think that we've tried to be really thoughtful about our dividends. And I would pull the lens back to, you know, more than, you know, about a year and a half ago, when it was clear rates had gone up, and we felt really confident that the portfolio was not only going to perform, but generate a really much higher step function, higher level of income. And we thought about how do we, what's the right way to share that with shareholders? And we introduced this notion of a supplemental dividend, so shareholders would have a very predictable understanding of how our earnings in higher rates or lower rates would flow through to them. We thought that, and we got a lot of great feedback on that.

I think that mechanism has worked really well. And so we had our base, our base dividend. At that time, we raised from $0.31-$0.33, and we had the supplemental. And, you know, what happened since then is rates have stayed higher for longer, portfolio is doing extremely well, and look, we've generated terrific earnings, record earnings four quarters in a row. And so what our shareholders have enjoyed is growing supplemental, and a base that was more than adequately covered. And so we wanted to think hard. We're not just complacent with that success. We wanted to think hard about, do we have the balance right?

We looked at our peers and their payout ratios, and we did a lot of work around our portfolio and sensitized, as you would expect us to, as rates drop, and making some thoughtful assumptions about credit performance. Do we, you know, do we have cushion, you know, to raise the dividend further? We felt really comfortable that even in a lower rate environment and making some appropriate assumptions around credit quality, that we have more than enough cushion to raise the dividend an additional $0.02 a share. So we did that. Naturally, you know, it's not this isn't complicated. We invest in floating rate assets. If rates come down, earnings are going to go down. Rates went up, earnings went up. You know, every shareholder should understand that.

It's some fundamentals investing in a BDC or certainly a BDC like ours. But what we would expect over time is if rates come down, we tend to look at the forward curve. We feel very comfortable continuing to earn our base dividend, but this... You know, we're putting more of our dividend in the base, and the supplemental will be lower if rates come down. And I think that's the cushion, is that supplemental. We just put up $0.51 a share. We raised the base to $0.37 a share. There was plenty of cushion there, and so we felt really comfortable. So to fundamentally answer your question, we looked at it holistically. We're going to just keep doing exactly what we're doing. We feel really confident in our portfolio. We don't need to change any levers.

We will continue to do what we have said, stay in our target leverage range. Certainly would like to tweak that higher, continue to invest in some of our specialty finance verticals. Those are, those are accretive, especially in a lower rate environment. But fundamentally, just continue to deliver great credit performance, and we feel good about the new dividend model.

Casey Alexander (Managing Director and Senior Equity Analyst)

Thank you.

Operator (participant)

Thank you. Our next question today is coming from Eric Zwick from Hovde Group. Your line is now live.

Erik Zwick (Managing Director)

Thanks. Good morning, everyone. Wanted to start first with a question on the pipeline, and I know in the prepared comments you mentioned that activity has been kind of seasonally slow to start, but not out of the range of normal. I'm just curious, as you look at the pipeline today, what it looks like in terms of the mix of new versus add-on opportunities, and whether also you're seeing any, you know, commonalities and any kind of themes in terms of industries or type of companies that are in the pipeline look attractive today?

Craig Packer (CEO)

... Sure. It's a mix, new opportunities, add-ons, refinancings, it's a mix. I would tell you that it's my hope/expectation that at some point this year we'll see a significant pickup in new buyouts. I mean, new buyout activity remains moderate, and I think that that should pick up, given generally a more stable rate environment, good economy, sponsors have lots of capital to deploy, and they really have a imperative to return capital to their LPs, and that should reflect itself in them selling companies that would result in new financings. So I would-- I was hopeful we might see that starting in the first quarter. We've seen some, but I wouldn't say it's a re-- well, resurgence, but at some point this year, you know, I think we will.

So it's a healthy mix. At some point, I think it'll be more skewed to new buyout activity. There are some of those, but it's not. I wouldn't call it robust. I would say it's sort of a reasonable environment that I would expect to increase over time.

Erik Zwick (Managing Director)

Thanks. Next, just looking at your common equity portfolio continues to grow in both dollar terms and as a percentage of total assets. You know, how are you thinking about these investments in terms of the overall concentration, and what is your inclination to realize some of the embedded gains and over what potential time frame?

Craig Packer (CEO)

Sure. So, look, I think that, for shareholders that are less familiar with our company, while technically all those investments you're referring to are common equity investments, you know, the vast majority of them are equity investments, in specialty finance verticals, where essentially they're portfolio companies, OBDC, where the underlying assets are pools of typically first lien senior secured loans. And so the credit characteristic of the vast majority of our common equity, more than, more than half of it, is an income stream. It's a dividend stream of a diversified portfolio of loans underwritten by management teams and companies with deep expertise in the domain that they're investing in.

So again, for those of you who are newer, examples, Wingspire to their asset-based lending business, Fifth Season, which is our life insurance settlements business, AerGen, which is our rail and aircraft business. These are all essentially portfolio companies that have very diverse pools of assets that generate income. And we are an equity owner, but we are getting an economic, very consistent, predictable, and growing income stream that we think will generate, you know, generally, double-digit ROEs. And we have been building each of these in a very sort of patient and methodical way. And in addition to that income stream, if our teams do a good job, we also have an asset.

An equity investment and asset is valuable, and be valuable to us, valuable to others, because we're creating enterprise value through our ownership stake in those businesses. We've grown that part of our portfolio, we're going to continue to do so, but it would be sort of off key a bit to think of that as a common equity investment. It's, from an accounting standpoint, it certainly is, but from our standpoint, it's really just a pool of assets that generate income to us, and that as we invest more, we will earn more. No plans to realize on any of that. We do have a much smaller number of either equity co-investments. We have a couple positions.

I mentioned PLI a minute ago, where we took over a business, but the combination of like, what I'll call pure equity is like 2%-3%. It's really de minimis. And so I think this has been a powerful, you know, return generator, to build long-term income and long-term gain for OBDC, and we'll continue to do so, but I would urge shareholders to spend a minute understanding it and come away, I think, really happy with it. When we did our Investor Day last year, we did a whole section on this. I think all of that's still available on our website.

So again, if you're newer, please, you know, please, take a listen or have, you know, email us if you're not, not sure how to get a hold of it, because I think you'll come away, not only relieved, but I, I would hope, excited about what we're building in some of these specialty verticals.

Erik Zwick (Managing Director)

That's a helpful explanation. Last one for me. Just looking at slide 13, there was about a $100 million increase in the portfolio companies rated either 4 or 5. So I'm wondering if you could just talk a little bit about the recent developments at those companies that drove the downgrades during the quarter.

Craig Packer (CEO)

Yeah. We, you know, I alluded to this on, on the call. You know, our, our overall rank, percentage rated 3, 4, 5, which for us is underperformance, stayed the same. But I made a point of calling out on the call that we did have an increase amidst those 3, 4, 5s in the 4 or 5 category. You know, we, we don't put out individual ratings, disclosure on each name, but, but you'll note, you know, we certainly, you know, we certainly have a couple of names on non-accrual. And so those - one of the movers was a non-accrual name. The other was one of our more significant markdown this quarter.

So, what I would offer you is, at this point in the cycle, given how our rates are. You know, we have expected, and we mentioned it again on this call, and we mentioned it pretty consistently on earnings calls, that we would expect to have a few credit issues, just given the magnitude of the rate move. And so a couple of those downgrades are reflective of credits that have been performing well below expectations, combined with higher debt burden, starting to catch up to them. But what I would say is the fact that the three, four, fives as a grouping has stayed stable, essentially. That's our watch list. Because our watch list has stayed stable. We're not adding new names of concern.

There's really just less than a handful of names that have been a concern for a year, and or, you know, that concern is growing as the, you know, their credit problems, you know, continue to fester in a higher rate environment. So that's what that is. I don't want to minimize it. These are the areas I spend the most time on with our workout team, and, you know, hope that we can reverse the course on a couple of these, but they are of concern. But again, you're talking about the overall portfolio, you know, 1.7% of the portfolio, you know, in aggregate. So it's a very small pool of a few names that we're going to continue to spend a lot of time on.

Erik Zwick (Managing Director)

I appreciate the answers, Craig. Thanks for taking my question today.

Craig Packer (CEO)

Great. Thank you.

Operator (participant)

As a reminder, that's star one to be placed into question queue. Our next question is coming from Paul Johnson at KBW. Your line is now live.

Paul Johnson (VP)

Yeah, good morning. Thanks for taking my questions. Kind of looking just at on, you know, fee income going forward, obviously, it was a very active quarter for you guys, but, you know, a slower year overall, I mean, $16 million or so fee income on a, you know, $13 billion portfolio. I mean, do you think, you know, in the relatively near term, maybe over this year, you know, there's potential to generate, you know, some fairly meaningful fee income there to offset some of the, you know, potential decline from rates?

Jonathan Lamm (CFO and COO)

Yeah, I mean, this quarter, we had a billion dollars of sales and repayments, and we had some, you know, a fair amount of prepayment-related income. As we said, that was some of the driver of the earnings. And I think that you can certainly expect relative to last year, where there was very muted activity, an increase, and for some of that fee income to represent, you know, an offset to, you know, to the rates. Depending on those rate moves, will it be dollar for dollar? You know, certainly we couldn't say, depending on the magnitude of those rate moves, but certainly a pickup in that activity will, you know, in overall activity, will mute or dampen the decline in income from rates.

Craig Packer (CEO)

Yeah, I hope at some point I talked about a world where there's a real pickup in M&A activity, in that world, there would stand a reason that we'd see a meaningful pickup in fees as well as accretion. You know, so I expect it to happen. This number has been it's a little bit better this quarter, but it's been sort of frustratingly low. I expect it to happen at some point. I don't want to not necessarily saying it'll happen in the first quarter either, but at some point in a much more robust M&A environment, it should pick up nicely.

Paul Johnson (VP)

Thanks. I guess, you know, as you know, the leveraged loan market starts to come back, you know, there's more syndicated activity. I mean, do you expect to potentially see, you know, some of those deals that are in the pipeline today, potentially, you know, flip over to the liquid markets?

Craig Packer (CEO)

I expect to see. Again, the public markets are wide open today. It's not something we have to wait to see. It's already happened. It's happening now. Our pipeline of deals we're looking at, you know, the sponsors are actively making choices about how they want to finance them. And today, despite a wide open public market, they continue to choose direct lending for certain deals in the public market, for certain deals, you know, as it has been and as it will be, and that's ordinary course decision making. You know, I would expect in this environment that we'll get repaid from some companies that choose to refinance in the public markets. We've seen a little bit of that.

I expect we'll continue to see some of that, particularly, you know, really high-quality companies in our portfolio that have been there for a while that have performed, delevered, you know, and can get a good execution. So that, again, that will generate some income from us, you know, as sort of the normal circle of life, if you will. I expect us to continue to do that. So I think it's just a normalized market. I think, you know, we had an environment a year ago when it wasn't a normal environment. Everything was going direct. You know, we, if we pull back, you know, we would have cautioned you not to assume that would stay that way forever. That was not a normal state of affairs.

This is a normal state of affairs and a healthy one, and one that we can continue to have really good success originating deals and getting repayments and keeping our portfolio invested.

Paul Johnson (VP)

Thanks. Appreciate that. And then, you know, public valuations, you know, have been surprisingly strong last year and into this year, you know, in the growth, you know, market, tech sector, I mean, really the broader market, the public markets as a whole. You know, I feel like that's maybe been a little bit contrary to kind of what's going on, you know, in the private markets last year with the adjustment to, you know, higher, you know, peak rates. I'm just curious, you know, how does that affect, you know, the companies in the upper middle market that you're looking at today? I mean, have you seen this kind of multiple expansion that we've had in the public markets?

Or, you know, I'm just curious to how that affects, you know, the market that you guys play in.

Craig Packer (CEO)

We continue to see private equity firms have a tremendous amount of capital, tremendous amount of expertise, and really a tremendous track record of finding opportunities to deploy that capital, generate great returns for their LPs. You know, private equity is a very, you know, it's a market that the institutional LPs like quite a bit, have significant exposures to and have generated, you know, really terrific returns in excess of public markets, you know, often, over many, many years. That's the market we choose to back. We work really closely with the private equity firms. And, you know, they were active last year. It wasn't quite the sort of bust year as they would all like. At some point, that will pick up and resume.

But I just want to make the point, which is an obvious one, but I'll make it anyway. We are on average, lending at 40% loan-to-value. We're lenders. You know, we wanna have a lot of equity cushion. We wanna have a commitment from the private equity firms in the form of capital, in the form of resources. You know, their role is to figure out valuation and whether they can get a great return. Our role is to provide a loan that we feel really confident in a downside scenario, we can get repaid. I think that part of the reason why you haven't seen as much private, you know, M&A resuming is the sponsors, I think, are being patient. They see some of what you're seeing.

They see the public market valuations high, and they're not going to rush to sell companies unless they feel really confident they can get the valuation that they deserve. That means they wait 6 months or a year, they're doing that, and I think that's probably why M&A has slowed down. But I don't want to sound flip or trite about it, but it's like not our problem. Our problem is just making sure we're backing good companies with significant equity beneath us, and that even if valuation comes down meaningfully, we're going to be covered. I think that's central to our underwriting thesis, and we don't get distracted by, you know, public market valuations that might be ephemeral or or even private market valuations that might be a bit too high.

Where we just go through our downside analysis, assume, you know, operational results are off, value multiples are lower, will we get our money back? And that's how we look at it.

Paul Johnson (VP)

Got it. Thanks for that, Craig. Those, those are all my questions today. Congrats on a good quarter.

Operator (participant)

Thank you. Next question is coming from Mickey Schleien from Ladenburg Thalmann. Your line is now live.

Mickey Schleien (Managing Director)

Yes, good morning. I apologize if my question's already been asked, but I'm juggling multiple calls. Craig, you mentioned that the BSL market is normalizing, and I'm interested in understanding how you see that impacting the spreads that you may be able to capture, you know, as the year progresses and going into next year.

Craig Packer (CEO)

Sure, Mickey. We did talk about this a bit. You know, in my prepared remarks, I mentioned it, you know, we've seen spreads tighten. It's tightened because the public markets have been open. They are open, they're normalized. They're not normalizing, they're normalized. And so that's a price check that private equity firms will look at. And you know, generally, it's a moderate deal flow environment, and the public markets have a lot of capital, private markets have a lot of capital, so you're seeing some spread compression. I think almost all of that has already taken effect in how we look at new deals. And I don't think it's going to go much higher than we are now, but it's on the tight end of historical ranges.

Absolute returns on our lending remain very high because current short-term rates remain very high. And so even if we do it, the Unitranche at 550 over current base rates, you know, we're still earning 11%+. But we all recognize that, you know, there's a good likelihood that in 2 years, that base rate will be meaningfully lower, and so will earn less over time. By the way, I think markets are coming to grips with exactly how fast rates will come down and what that will look like. And, you know, maybe there's a bit of a reconsideration there, but we're assuming we look at the forward curve. So spreads are tighter, they're livable, they're more on the annoying category than in the, you know, the returns work for us? We still get great returns.

And it's a more just a back to a more typical market with sponsors and companies picking between private and public markets. We continue to get a premium for private solutions, and that premium is not only a higher spread, but essentially the OID that we get to underwrite at, we continue to offer a premium. But I always like to remind clients and shareholders is you got to think about it on a relative basis. You know, we're, we may not be earning as much, but all the markets are tightened, and we're still earning a nice premium, and we earn a premium in all market environments. And we'll... You know, the relative premium should stay the same, but the absolute return will move around based on market conditions.

Hopefully that gives you a little bit of context.

Mickey Schleien (Managing Director)

It does. I appreciate it. Thank you very much.

Craig Packer (CEO)

Thank you.

Operator (participant)

Thank you. Next question today is coming from Kenneth Lee from RBC Capital Markets. Your line is now live.

Kenneth Lee (Managing Director)

Hey, good morning. Thanks for taking my question. Just to piggyback on the broadly syndicated loan questions. Do you anticipate any kind of shift in either the sectors you're focusing on or underwriting or perhaps the types of investments you could be making, either within the capital structure or the size, just given the normalization of the leveraged loan markets? Thanks.

Craig Packer (CEO)

Well, so we're really boring on this. It's not for, like, lack of thought on our part. You know, we really like recession-resistant sectors with very predictable earnings in non-cyclical parts of the market. You know, we're not trying to time the economic cycle. And we track private equity activity. And so consistently, where we find the best opportunities, software, insurance brokerage, some parts of healthcare, food and beverage, a lot of services businesses, distribution businesses, that's our sweet spot. Those have been our most significant sectors for years, and we continue to see a lot of activity there. Software continues to be the best sector that we have. We obviously have several funds dedicated to software space, but it's the biggest single industry sector for many of our funds.

Continue to like that a lot, and we're not going to deviate from that. And so, you know, I think that should be reassuring to investors. We make seven-year loans, even if we thought the economy might be really good for cyclicals for a year or two, you know, we're not willing to underwrite, you know, stable economic conditions for seven years, and so we think that that's the right approach. So, you know, no change. We lend to a lot of businesses that the underlying economic feature is a very predictable and recurring revenue stream. That's the single defining factor of our underwriting process, and you can find those types of businesses that serve a variety of markets, depending on what they do, and that's really what we seek out.

Kenneth Lee (Managing Director)

Got you. Very helpful there. One follow-up, if I may. In terms of the new investments, I wonder if you could just give a little bit more color in terms of what you've been seeing in terms of terms and documentation on new investments and whether there's been any change just given the current landscape. Thanks.

Craig Packer (CEO)

Overall, terms and protections remain very strong for direct lending, and I would sort of underscore this, that the protections that we get are significantly better than what's in the public markets. That's fundamental to what we do. You know, we care not only about the business and the returns, but the credit protections. Given our significant exposure to the companies, given that illiquidity that we have, we need to be in a position to protect ourselves. And the CLOs that buy public loans simply don't have nearly the same credit protections. It's really pretty dramatically different, in particular, in areas around protecting our collateral, cash flow leakage, and the like. So we just get much better credit protections, fundamental. We won't sacrifice that.

Have not, will not. It's—they're on the edge. There are, you know, a few things that can creep in when markets are as strong as they are now, you know, which we will do selectively if the rest of our, you know, credit protections and economics are appropriate. But I'd say, fundamentally, the leverage on the deals, on the value of the deals, the credit agreements are fundamentally consistent with what we've been doing the last seven or eight years. No change. You'll read about portability and PIK. There's a couple of features that have crept in. You know, we do those, you know, in very, very small number of circumstances for really, really high-quality credits in a very reasoned way.

It's not reflective of overall market conditions, but you will see a couple of deals done in that manner. I think for the right credits, you know, we're willing to consider those, the market's willing to do it, but nothing that would sacrifice our credit quality. It's fundamental to us, and I feel really good about that for every loan that we do, and if not, we won't do it.

Kenneth Lee (Managing Director)

Got you. Very helpful there. Thanks again.

Operator (participant)

Thank you. Next question is coming from Maxwell Fisher from Truist Securities. Your line is now live.

Maxwell Fisher (Equity Research Analyst)

Good morning. I'm calling in for Mark Hughes. In the prepared remarks, you mentioned that the net leverage ratio ticked down, which we've seen, for the last several quarters. Is there a specific range you had in mind for 2024, 2025, as investment activity presumably starts ramping up?

Craig Packer (CEO)

The range is the same range we've been at, we, as we said a long time, 0.9-1.25. You know, this quarter we had, you know, $1 billion of origination, $1 billion of repayments. You know, we can't manage that leverage ratio with a scalpel. It, you know, it's a little bit. It's just a function of deal flow. I, on the margin, I'd prefer it to be a tick or two higher, but there's nothing deliberate about us trying to tweak it a bit lower. I think it's just a function of deal flow. You know, we'll try to optimize a little bit. Our returns are terrific. We're putting up record returns, record ROE, record NII, record NAV.

and so I think it should be reassuring that we can do all that and have leverage not be at our peak. We're not stretching to do deals. We're not stretching to max leverage to try to grind out returns. We can do it very comfortably, and it gives us a little bit of an arrow on the quiver, over time, to offset if there's a little bit of rate reduction.

Maxwell Fisher (Equity Research Analyst)

Yeah, that's, that's helpful. And so you mentioned the industries that you find attractive, but are there any particular industries in your portfolio that are having more credit issues than others?

Craig Packer (CEO)

We have very few credit issues, so there's no sectors that are having more credit issues than others. We have almost none. I would say overall, really consistent across the board, low single-digit revenue, EBITDA growth. There's a couple of consumer-facing businesses that, you know, are having a bit of struggle. There's a couple of industrial businesses that were benefiting when supply chains, you know, were loosening up, but maybe they're facing some commodity price pressures or some supply chain, you know, challenges. So I'd say every company is doing perfectly well. We do have a watch list, but there's no thematic comments I would make about areas of great weakness, and I think that speaks to the broad strength of our portfolio.

Maxwell Fisher (Equity Research Analyst)

Okay, got it. Thank you.

Operator (participant)

Thank you. We've reached the end of our question and answer session. I'd like to turn the floor back over to management for any further closing comments.

Craig Packer (CEO)

Thank you so much for everyone for joining. We're really pleased with the quarter. If you have any other questions, please reach out. We'd love to engage with you, and we look forward to seeing you and speaking with you again soon.

Operator (participant)

Thank you. That does conclude today's teleconference and webcast. You may disconnect your line at this time, and have a wonderful day. We thank you for your participation today.