Seeking Alpha

Owl Rock Capital Corporation: Q3 Results Cause Us To Adjust Our Target Price

|
About: Owl Rock Capital Corporation (ORCC)
by: Williams Equity Research
Williams Equity Research
Long/short equity, special situations, dividend investing, oil & gas
Summary

Owl Rock Capital Corporation recently IPO'd but Williams Equity Research was intimately familiar due to its relationships on the institutional side.

Owl Rock's lack of non-accruals, overall portfolio quality, and scale quickly catapulted its BDC toward the top of the segment.

Let's critically evaluate how Owl Rock Capital Corporation performed during its first full quarter as a publicly traded BDC.

Background

We've written several private and one public article on Owl Rock in the short time it has traded. Newer subscribers/followers might not yet be aware that one of Williams Equity Research's ("WER") competitive advantages is our lead portfolio manager has been performing in-depth due diligence on private offerings for large institutions for over ten years. How does that help subscribers/followers?

Source

Most REITs and BDCs did not come out of thin air - private capital from sovereign wealth funds, pension funds, high net worth individuals, and other sources are usually used to construct the initial portfolio. Bain Capital Specialty Finance (BCSF), which WER was the first to write about on Seeking Alpha, came about in exactly this manner. This evolution provides an asset base that can grow over time and be fine tuned to meet the desires of the public markets.

Source

Once aligned, the REIT or BDC tends to have an initial public offering ("IPO") which theoretically allows private investors to lock-in an illiquidity premium. It takes a lot of manpower, individual asset-level due diligence, and boots on the ground to build up a portfolio whether it consists of loans or buildings. Public investors don't want to wait years for an asset pool to generate an income stream and are happy to pay a premium to buy shares in an already functional stock with a track record of paying reliable dividends. That premium fluctuates in value but is generally positive.

In the case of Owl Rock Capital Corporation (ORCC), several firms reached out to Williams Equity Research for our opinion on the private vehicles Owl Rock has developed since its creation by mostly Goldman Sachs (GS) alumni. We did not personally invest in any of Owl Rock's funds but we did critically analyze all the public filings associated with them over the course of several years. Given Owl Rock's relatively recent inception and concentrated focus, this essentially encompasses the firm's entire investment history. We've been following the management teams, portfolios, and strategies of each of Owl Rock's private debt investment vehicles. In summary, when Owl Rock Capital Corporation IPO'd, this was not news to us - we knew exactly what was going on and who was doing it - public article published in July 2019 shortly after the IPO.

We've already produced several dedicated articles on Owl Rock that are restricted to our subscribers. This article will serve primarily as an update to our previous work which includes the "Owl Rock Vs. Golub Vs. Bain: This BDC Battle Is Going Down To The Last Round" public article published in July 2019 shortly after the IPO.

Source: Owl Rock

Owl Rock provides a good overview of how the portfolio has grown over time.

Source: Owl Rock

Owl Rock Capital Corporation debuted as the second largest publicly traded Business Development Company. As we've stated many times, while BDCs do not need to be as large as Ares Capital Corporation (ARES), the largest BDC by market capitalization, to succeed, there are inherent advantages with scale. We generally see this around the $1.0 billion to $1.5 billion portfolio level based on fair value. Below this, BDCs may struggle to obtain investment grade credit ratings, generally pay higher interest rates, and fail to achieve the level of portfolio diversification we prefer. Owl Rock mitigated all these concerns by the time ORCC completed its first day as a publicly traded stock.

Owl Rock has a very rare trophy somewhere in its headquarters off Park Avenue in Manhattan; to the best of our knowledge, the entire firm has a 0.0% annual average default rate. In order for that to reconcile, we need to confirm several items:

  • High if not exclusive allocation to the top of the capital structure;
  • Lower asset level yields than many or most of its peers signaling lower risk portfolio companies (8.9% as of the end of Q3);
  • Modest portfolio company leverage compared to many or most of its peers (5.5x as of the end of Q3); and
  • Minimal exposure to cyclical industries.

If these were not consistently in place, it would simply be a matter of time before defaults were to occur. Let's see to what extent Owl Rock is following these parameters starting with the portfolio.

Portfolio

Source: Owl Rock

ORCC ended Q3 with 99% senior secured, 79% first lien investments, and 100% floating rate debt investments. This is in line with previous periods. Diversification remains excellent with 96 portfolio companies across 27 industries. For those that track the sector closely, that 96 figure may seem low given its size. It is, in fact, and many smaller BDCs like TCG BDC Inc. (CGBD) have well over 100 portfolio companies (141 for CGBD as of the end of Q3).

Source: Owl Rock

This ties into one of ORCC and the broader Owl Rock organization's competitive advantages: taking down very large tranches of loans, and in some cases, the entire loan. Within ORCC's filings and presentations, they call this serving as the "anchor" to large financing operations. This strategy allows Owl Rock to potentially reduce the risk of a default within its portfolio compared to taking smaller tranches of more loans. Owl Rock targets upper-middle market companies with significant operating history and a long track record of responsibly handling leverage. Most BDCs dip into the lower-middle market as they can obtain higher yields with less competition from other lenders. That doesn't mean Owl Rock's strategy is necessarily better or worse, but it does mean investors gain additional strategy diversification by adding Owl Rock Capital Corporation to their portfolio.

Source: Owl Rock

While the gross dollar volume of risk rating 3 loans increased from $416.8 million to $447.2 million, they declined as a percentage of the portfolio from 5.7% to 5.4%. Going back further, the percentage of risk rating 3 loans has fallen even more so. ORCC is the only BDC we track with current and historical exposure of 0.0% to loans rated 4 and higher. As a reminder, here's the rating scale for ORCC (it varies slightly between BDCs so do not assume all systems are equal):

Source: Owl Rock

Income, NAV Per Share, & Debt

Source: Owl Rock

Net investment income ("NII") per share of $0.36 last quarter was the lowest in ORCC's recent history. There weren't any material changes in net realized and unrealized gains (losses) per share. Due to the lack of defaults and loan problems in general, NAV per share has remained very stable and came in at the mid-point of the trailing four quarters at $15.22.

The debt situation is unusual compared to peers; while total debt has increased moderately from $1.97 billion in Q3 2018 to $2.46 billion as of the end of Q3 2019, debt to equity has gone down meaningfully from 0.66x to 0.39x over the same period. While a few top quality BDCs, such as Golub Capital BDC (GBDC), have resisted raising debt in conjunction with the relaxed rules on BDC asset coverage ratios, zero of the BDCs we cover (and we cover most) have reduced leverage ratios like ORCC has. This was accomplished by doubling net assets while increasing debt only 25%. There are mechanical reasons why this occurred due to ORCC's recent history as a private, capital-call driven investment vehicle, but the reduction in leverage is nonetheless accurate.

Source: Owl Rock

The term structure of ORCC's debt is favorable and in line with BDC heavyweights such as Ares Capital Corporation. The borrowing base is well diversified with minimal maturities prior to 2024.

So what's the story on the reduced net investment income per share?

Source: Owl Rock

In terms of raw numbers, total investment income was up from $176.1 million in Q2 to $188.2 million in Q3 2019. Reduced interest expense was more than offset by higher management fees. Performance based incentive fees kicked in for the first time in Q3 and were a significant $19.7 million. Total expenses grew significantly to $81.7 million, or 43.9%, but were lowered by $31.7 million in fee waivers. That caused net expenses to fall slightly compared to Q1 and Q2 of 2019. This is more significant than it might appear; ORCC's portfolio has grown considerably over this time so it is expected that gross fees and expenses would rise as well. As a result of the generous fee waiver (not something we say often), net investment income for Q3 of $137.9 million was much higher than any previous period and a full 15.3% greater than Q2. We want to see the reliance on fee waivers cease in the coming quarters.

The mathematically inclined among us know what must come next.

Source: Owl Rock

The only way all the facts presented can reconcile is if the share count has increased considerably. That is in fact the case but no surprise to those following the company or this analysis. It's the same reason the debt to equity ratio has fallen dramatically; ORCC has raised considerable equity and needs to put it to work. While the decline in NII per share is an issue, it is likely short term in nature and not something that should frighten investors looking to hold ORCC long or even medium term.

Distribution

Owl Rock's Q3 2019 annualized dividend yield was 8.7%. The distribution yield and stock price are supported by a sizable $150,000,000 10b5-1 share buyback program which is initiated whenever the stock trades below net asset value ("NAV"). The current cash yield is 7.11% based on the last base distribution payment of $0.31 per share.

Source: Owl Rock

Without reducing fees, decreasing distribution coverage ratios, or increasing leverage, the yield derived from the portfolio must rise in order to increase the distribution to investors, all other things equal. In ORCC's case, that yield has decreased in the past year from 9.4% to 8.9%. This is somewhat expected; most high quality BDC management teams have commented that the competition for the best loans and lower interest environment has compressed yields. This is a notable drop, however, and reduces the probability that Owl Rock will raise the baseline dividend rate.

Source: Owl Rock

Owl Rock is attempting to move the needle the other direction, however, as shown by its new investment activity shown above. Specifically, the average weighted interest rate of 8.7% on new loans in Q3 2019 was higher than any other quarter since mid-2018. The best way to measure Owl Rock's progress here is the spread of new loans over LIBOR. Realistically, it isn't fair to gauge the interest rate on new loans on an absolute basis; it's best to judge the 6.6% spread over LIBOR which is significantly higher than any other recent quarter.

Source: Owl Rock

Distribution coverage, even when incorporating Q3's special dividend of $0.02, is excellent and consistently exceeds 100% and averages 110%. The metric rises to 115-120% in recent periods using the base dividend of $0.31 which is what most analysts and publications cite.

Source: Owl Rock

Owl Rock gives us better than average transparency into future fixed and special dividends. The Board of Directors have already approved 2019's base dividends and 2019 and 2020's special dividends. This results in a $1.56 estimated but mostly pre-approved distributions in 2020. As of today's close (11/7/2019), that's a 9.0% distribution yield. Compared to other top quality BDCs like Goldman Sachs BDC (GSBD), Golub Capital BDC, and TPG Specialty Lending (TSLX), only Goldman Sachs BDC's yield is in the same ballpark as ORCC's rendering it quite attractive.

In aggregate, our assessment of ORCC remains favorable and is reinforced by both Q3's financials and the key metrics we've projected going forward. We reserve risk ratings and specific entry points for subscribers, but suffice to say we are adjusting our desired entry point for ORCC slightly higher after performing this analysis.

As always, thank you for reading and commenting. -WER Portfolio Managers

Disclosure: I am/we are long BCSF, GBDC, GSBD. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: We may enter into long or short positions in any of the stocks mentioned in this article at any time. We may have outstanding limit buy or sell orders on any of the stocks mentioned at the time this article is published.