Owl Rock: 9% Yield In These Credit Markets
Summary
- Owl Rock Capital Corporation finished its first full year on the market.
- Until the beginning of the pandemic, the stock was trading at a 14% premium to NAV.
- As anticipated, ORCC is performing and rallying back to its pre-pandemic levels with its peers and is approaching a 1.0x price/NAV trading level.
- Given the stock’s rally, ORCC’s quality portfolio will produce an 8.9% yield for investors in 2021 plus equity returns as it closes the gap between its NAV and the market returns it to its premium valuation place in the BDC industry.
Owl Rock Capital Corporation (ORCC) beat expectations for the quarter and gave a glimpse in Q4 of 2020 that moving forward, waived management fees will not hamper its operations or investor's 9% dividend yield.
Since last discussing ORCC in December, the company has seen total returns of 10% and has already started closing the gap on its price/NAVPS discount. Now trading at a 5% discount to NAV, the return to NAV is tangible within this year, and climbing higher is just a point of sharing this premium young BDC's story with the rest of the market.
For those investors who understood the undervalued premium portfolio that Owl Rock Capital has been building in ORCC, they saw total returns of 35% from Q1 2020 to Q4 2020.
CEO Craig Packer, COO Alan Kirshenbaum, and Owl Rock's Team are driving ORCC toward a portfolio value of $11.5B that will generate a total investment income of $1B annually. This means long-term high cash dividends for investors as Owl Rock Capital, and ORCC seeks to continue to expand their reach in the alternative asset and BDC industry.
Company and Management Overview
Depiction created by the author using the company's images sourced from the last article
2020 was ORCC's first full year on the public markets after its July 2019 IPO. The company is currently a $5.5B market cap, $5.7B NAV BDC that is focused on investing in the upper end of middle-market companies with EBITDA of +$90M. ORCC is managed and advised by Owl Rock Capital LP (Owl Rock Capital) which is an alternative asset management firm based out of NYC that oversees $25B in AUM.
Owl Rock has been in the news lately as the company and Dyal Capital Partners announced they are merging to form Blue Owl Capital. Blue Owl will enter the public market via SPAC Altimar Acquisition Corporation (NYSE: ATAC). There will be no change in the management/advisor structure for ORCC, Owl Rock Capital and Dyal are seeking to generate synergies through at-scale portfolio management.
The proposed merger has recently encountered some friction from Sixth Street Partners which manages a competitor BDC, TSLX. Dyal has a minority stake in Sixth Street and Sixth Street publicly seems to be nervous about ORCC's advisor having information about Sixth Street and so they have filed a lawsuit (C.A. 2021-0127). The real reason though maybe that Sixth Street has recently broken away from TPG and wants to solidify its autonomy by forcing Dyal to sell Sixth Street Dyal's ownership in Sixth Street. Investors shouldn't be too concerned about the management companies though as ORCC's operations will persist regardless with an attractive 8.9% yield for the year.
Also to note of late for ORCC is that on February 23, 2021, the board of ORCC added Ms. Melissa Weiler to the board. Ms. Weiler was formerly a Managing Director at Crescent Capital Group, a Los Angeles-based asset management firm, where she worked since January 2011.
Place Among Peers
In terms of NAV and Market Cap, Owl Rock is at the top of the BDC industry given its massive close to $11B portfolios which has been acquired at a leverage ratio of about 0.95x debt-equity.
Sourced from Raymond James BDC Weekly Insight Report Feb.18, 2021
Comparing ORCC to these peers and it becomes apparent that ORCC has the potential to continue to rise.
Data byThis chart depicts the top BDCs based on AUM and some from Cliffwater's BDC index. The chart shows that ORCC is in the middle of the pack. It is time to review the NAV and underlying portfolio of ORCC for this past quarter and 2020.
NAV Evaluation
An investor wants to see a historical steady or increasing NAV trend for a positive growing BDC. Since Q1 of 2020, the NAV of ORCC has increased from $5.585B to $5.746B. I will note, however, that the NAV has not returned to its pre-pandemic height at the end of 2019 of $5.977B.
For shareholders, NAVPS has increased from $14.09 to $14.79 in 2020. The stock is, currently, trading at a price/NAVPS of 0.95x. This should be exciting for investors as reviewing historical data suggests a 5% equity upside in addition to the 8.9% dividend of the stock ignoring any potential special dividends for 2021.
Created by the author using company 2020 10-K and 10-Qs
Portfolio Evaluation
ORCC has a total portfolio composed of 119 investments valued at a cost of $10.575B and a fair value of $10.842B representing an awesome 102% coverage. As an investor in ORCC, you own this portfolio less the debt that was used to acquire this portfolio. Having a solid portfolio for a BDC investment is key to generating the long-term dividend and equity returns that investors seek when they invest in BDCs and fund-like stocks.
The portfolio consists of 77.5% ($8.34B) first-lien senior secured debt investments, of the first-lien, 37% ($3.08B) are considered uni-tranche debt investments. 18.5% or ($2.00B) of the portfolio is in second lien senior secured debt investments, 0.5% ($50M) unsecured investments, 2.5% ($270M) in equity investments, and 1.0% ($108M) in investment funds and vehicles.
Created by the author sourced from CEO comments in 10-K
In terms of the underlying industry concentrations, ORCC presents a broad-based portfolio conforming to the classic portfolio diversification strategy of BDC and funds in general to limit non-systematic risks for investors.
Sourced from Company 10-K presentation
The only portfolio company to note on non-accrual or in a precarious financial situation was Swipe Acquisition Corp. Swipe is a gift card company and due to the shift in consumer habits during the pandemic saw a sharp decline in its business. Almost all of the realized losses associated in the quarter for ORCC were related to ORCC's investments in Swipe.
Portfolio Leverage
Data byOver the last year, ORCC has been slowly but surely leveraging up the portfolio in terms of debt/equity. This is good as it means the company will be more in line with the industry which will help in doing comparables moving forward.
Created by the author using company 2020 10-K and 10-Qs
In the last earnings call CEO Craig Packer noted that the firm is aiming for a leverage ratio of 1.0x
We ended the quarter with leverage of 0.87 times which is up from 0.46 times at the year end 2019. We continue to be pleased with the progress we have made towards our targeted range of 0.9 to 1 in a quarter times. - Criag Packer CEO Owl Rock Capital Q4 Earnings Call ORCC
Portfolio Yield, NII, and Dividends
An investor wants the NII to increase year over year and cover the dividend for a positive long-term investment BDC. Net-investment-income-per-share ("NIIPS") has been trending down for the last year from $0.37 in the first quarter, to $0.29 in Q4 and as a result, has not been able to cover its dividends distributions in full. The coverage of the dividend by the NII is fundamental for a good BDC.
Created by the author sourced from company 10-K and 10-Qs
ORCC's non-conformance to this standard means that investors need to pay attention.
Two important pieces of information in regards to NII and Dividends that point to the declines seen above are that the company this past quarter will stop waiving its management fees and the special dividend from the IPO is being discontinued. The stock, however, has traded up since its earnings report, partially as part of the market shift into financials as a result of the perceived return of inflation and thus an expectation of a future with higher interest rates which would behoove financial institutions and lenders like ORCC who have non-fixed rate loans.
Sourced from company 10-K
The chart above highlights how valuable waiving management fees was to net-expense ('NE'). Adding back the waived fees would equate to NII of $386M instead of $519M. However, it appears the NII will be around $120M per quarter moving forward based on Q4 results where the hefty management fees were not waived. With 389 million shares, that works out to about $1.23 for the year to cover dividends. At the stock's current price of $13.98, that is an attractive 8.7% yield.
The chart below shows how this last quarter NE jumped from $60M in Q3 to $105M in Q4 as a result of the end of the management fee waiving. However, NII only declined slightly from $126M in Q3 to $114M in Q4. This is positive as it shows the portfolio's underlying total-investment-income has reached a level where the company can return achievable NII to investors. The TII for the quarter was up 18% to $206M compared to Q3's $221M TII.
Sourced from Company 10-K presentation
To recap 2020, the portfolio generated $803M in total-investment-income ('TII') which represented an 8.3% yield.
Sourced from Company 10-K presentation
Moving forward a rate of 8.3% yield on the portfolio of $10.8B would result in TII of $890M accounting for NE to be $110M for the quarter moving forward, and the company will generate $450M in NII for 2021 which works out to about $1.15 per share or an 8.2% yield at the company's current share price.
In the Q4 earnings call, Craig Packer's expressed his goal of achieving a portfolio size of $11.5B with $1B in repayments either this year or next. In the current environment, this would mean an incredible deployment of more capital in new investments which would probably mean the company would see an increase in the uni-tranche concentration of the portfolio as this seems to be the yield-generating investment product of choice right now. Uni-tranche loans don't come without risk, but it would be risk parsed out down the capital structure instead of all at one level.
There is also the possibility that if rates move up to counter inflation repayments could hit that number. This is a broader systemic market risk discussion which I will delve into briefly in risks. Based on the company's quantitative input table in the 10-K report it seems highly likely that the portfolio could generate 10% in 2021 which will help Mr. Packer reach his goal a little early.
Sourced from company 10-K
Brief WACC Discussion
The company currently has a WACC of between 5.9% and 6.9% depending on if you use the CAPM method or Dividend Capitalization Method for equity return rate moving forward.
Image is a screenshot with borders added by the author of the WACC definition formula image on Investopedia
- V = Enterprise Value = $11.3B
- Equity = $5.7B
- Dividend Cap. Method Return Rate = $0.31 (expected dividend)*4 (quarters)/14.74 (NAVPS) = 4.3%
- CAPM = 1.4% (10y US Treasury) + 1.04 (ORCC-SPY daily Beta since IPO) *(10% (SPY 5-yr annual return) - 1.4% (10y US Treasury)) = 5.3%
- Debt = $5.57B
- Debt Expense Interest Rate = 3.3%
- Tax Rate = $2M (Taxes) /$803M ('NII') = 0.25%
- WACC using Dividend Capitalization Method = $5.7B/11.3B * 4.3% + $5.57B/$11.3B * 3.3% * 1 = 5.9%
- WACC using CAPM Method = $5.7B/11.3B * 5.3% + $5.57B/$11.3B * 3.3% * 1 = 6.9%
ORCC's Weighted Average Cost of Capital represents the required rate of return expected by its investors. Therefore, it can also be thought of as the firm's opportunity cost, meaning if ORCC can't find a higher rate of return elsewhere, ORCC should buy back its own shares.
WACC is important to keep in mind in the context of ORCC's investment portfolio. If an investment in a portfolio company by ORCC doesn't generate a return above the calculated WACC of 6-7% then there is no long-term value being generated for ORCC and its shareholders. The 8.3% yield on debt accruing investments is a positive sign that the value spread is between 1.3-2.3%. These are thin margins, but it is also a sign that the firm is creating long-term value in terms of present value for investors as long as it is investing above its WACC.
Expenses and Fees Evaluation
The above charts and graphs give investors a good context for the ratios in the table below. Since its IPO, ORCC has been waiving management fees and as a result, has had an awesome 70% NII/TII and 30% NE/TII ratio compared to the industry. However, with the ending of this program, the 51% NII/TII and 47% NE/TII ratios are returning as seen in Q4 to more industry-standard ratios where the expenses and NII are about evenly split.
The above analysis went into detail about how these new NE and NII ratios should play out in terms of NII for the year and thus dividend coverage. We can break it down another way though using these ratios in the table below.
Essentially TII will be expected to be around $890M and NII at 50% of TII, as a result, will be $445M which when split among the 389 million shares will result in about 7.7% yield at the current 14.74 NAV or 8.7% yield at the current $13.98 stock price. Investors should be pretty excited by these potential dividend returns for themselves.
Created by the author using company 2020 10-K and 10-Qs
Understanding a BDC Investment
***If you are a BDC investor, feel free to skip this part as this is a discussion I have gone into previously in my WhiteHorse Financial (WHF) article.
This is a BDC investment for an investor.
A business development company (BDC) is a company that operates like a private credit or equity firm but trades publicly. BDCs are attractive for income-seeking investors and investors seeking to indirectly diversify their portfolio into middle-market US companies. Like a REIT, 90% of profits generated from the BDC are distributed to the shareholders via regular dividends. The current low-interest-rate environment allows BDCs to access cheap capital during one of the biggest and longest growth expansions in US history. As a result of the positive economic tailwind and cheap rates, investors have been seen positive dividends and stock total returns.
BDCs were created in 1980 with the passage of the Small Business Incentive Act to increase access to capital for growing businesses. Business Development Companies (BDCS) in the last decade have started to transition from investing in financially stressed companies and have slowly started to take the place of banks in offering middle-market loans as the banks have stepped away due to regulatory pressures. These middle-market loans are offered to mid-size US companies across various sectors. Many BDCs today are publicly traded and operate similarly to private debt/equity firms in that they provide private debt and equity investments for private companies.
The BDCs generally make loans to these companies with interest at L + 6.00% to L + 10.00% after having borrowed at modest rates of about 2-4%. BDCs are regulated by the government and the government has set regulations around limiting the amount of debt the BDCs can borrow to finance their portfolio ventures. Under the Small Business Credit Availability Act (SBCAA), which was passed in 2018, "regulatory asset coverage requirements for BDCs will decline to 150% of debt from 200% of the debt, allowing BDCs to increase debt-to-equity leverage to 2.0x from 1.0x".
The increase in leverage for BDCs has to be approved by the shareholders, but since 2017, BDCs have seen the industry's debt-equity ratio increase from 0.65x in 2017 to 1.0x in 2020. While the BDC's portfolio leverage has increased, the debt that they are investing in has also increased in its leverage. Typical deals for private companies are now 4.0x-6.0x Debt/EBITDA according to a recent US PE Middle Market Pitchbook Report.
BDCs provide an alternative asset investment of direct lending to US middle-market companies with higher yield potential than traditional investments as the BDCs can command a higher rate than banks. The risk for BDC investors is concentrated in the portfolio and management of the portfolio.
The portfolio presents a classic credit market risk. Though management of BDCs generally employs classic portfolio management tactics such as diversification, cost of capital allocation analysis, and MPT that are generally enacted to protect against non-systematic risk factors, this does not protect investors against the systematic risks of the US credit markets. BDCs a part of the US credit market and as a result are highly correlated to the S&P 500 as the JP Morgan chart demonstrates. This means that high yield bonds and BDCs are highly susceptible to systematic risk shocks, especially those that impact the credit markets.
Sourced from JP Morgan Asset Management January Report
Investors also have to cognizant of fees and expense ratios for BDCs as those discussed in-depth in this article as these management fees and expenses can cut into the dividend payout that investors expect from these high yield investments.
The private debt market which the BDCs participate in is a large and growing market and BDC investors have enjoyed the momentum of this market with equity and dividend returns over the last decade of economic expansion.
Understanding Risks
Non-Systematic Risk
From a non-systematic risk standpoint in the middle market context, ORCC has a very well-diversified portfolio in multiple industries and, as highlighted above, concentrated on first-lien loans. Only one industry comprises more than 10% FMV of the entire portfolio. The company also has only one company on non-accrual which is incredibly low.
In the context of the credit markets, ORCC enjoys a triple B rating for itself from the top credit rating agencies including S&P, Fitch, Moody's, and Kroll. 77% of the loans in ORCC's portfolio are in first lien loans and 99.99% of the entire portfolio is based on floating interest rates. This can be beneficial as float rate loans will be flexible in the event of rising interest rates and would be beneficial for ORCC.
Systematic Risk - Default Rates
The potential rise of interest rates is important to dwell on because, in the past month, the 10-year Treasury yield has gone from 1.0% to 1.4%. This is a positive sign for the long-term economy as it means investors are divesting from Treasury bonds which are seen as one of the safest long-term asset classes, but it also means that the risk-free rate just went up, and thus the WACC as well went up. This means that future cash flows will be discounted at a high rate and higher rates of return are important.
Fortunately for ORCC, their loans are floating rate. This means that their future cash flow adjusts with interest rates. However, for companies who don't have their operating cash flows tied to interest rates such as technology companies, their future cash flow remains at the same level but is discounted more heavily driving down the net present value of the firms and is the reason for recent market shocks as the markets, for example, the S&P 500 are heavily concentrated in tech; 30% at the time of this article. Firms can counter this by raising their long-term prices, but that leads to price inflation and customer relation shocks that can jeopardize future cash flows as well. The return of inflation and the rise of interest rates are systematic risks that are out of ORCC's control.
From general systematic risk analysis, 2020 has showcased that the credit markets and in turn the BDC market are very exposed. The default rate for high yield bonds in the US is expected to be around 8-9% in 2021 according to the below Moody's charts. 2020 has also shown that the loans made by ORCC's portfolio managers were the right long-term conservative investment approach as ORCC has a 0.5% non-accrual rate at FMV.
Sourced from Moody's
The two Moody's charts here give investors a sense that the default rates are beginning to start their trend down. The lowering of these default rates is probably part of the reason why the 10-year Treasury bonds have started to be divested over the last two months as investors get a growing sense of confidence in other bond and yield investments.
Sourced from Moody's
Another thing to keep in mind when thinking about ORCC's risk is to look at its debt offerings. The company has issued a combination of Special Purpose Vehicles, Notes, and CLOs. From 2019-2020, The US Government Accountability Office (USGAO) launched a study into whether leveraged loans such as those that BDCs participate in posed a systematic risk to the economy as the leveraged loan market has grown from $500B in 2010 to $1.2T in 2019. The USGAO reported that it and the agencies involved, "have not found leveraged lending to significantly threaten stability".
The USGAO reported that "Present-day CLO securities appear to pose less of a risk to financial stability than did similar securities during the 2007-2009 financial crisis."
What was also interesting to note was that the report also noted that "Present-day CLO securities appear to pose less of a risk to financial stability than did similar securities during the 2007-2009 financial crisis". This is an important last note because it means that the underlying debt that the CLOs are built on and that ORCC has issued is considered very stable. ORCC has over $1B or 20% of its debt issued in CLOs. From an investor standpoint, this USGAO report can be seen as reassuring.
Eclectic Systematic Risk - LIBOR to SOFR
Another interesting risk is the transition from LIBOR at the end of 2021 and what the BDCs will use as the underlying credit market rate. Commentary from ORCC and other BDC management throughout the year will be interesting on this subject though it appears that SOFR will be the replacement. SOFR will be the overnight lending rate and is notably lower than LIBOR currently. This could have broad implications on interest income and expense and thus net investment income which is the backbone of dividends for BDCs. Some are calling it the Y2K of credit markets. Fortunately, most interest rates for investment firms and ORCC are floating and it is expected to be a smooth transition, but it will be interesting to see how the industry addresses this as a whole as there could be moments of arbitrage.
Conclusion
ORCC delivered on a tough year for the credit markets. Distributing solid dividend returns in excess of 10% and equity upside in the midst of the pandemic and volatile credit markets with high default rates. ORCC ended the year with a non-accrual rate of less than 1% and a portfolio value coverage ratio of 102%.
It seems that the industry and analysts are once again taking note of ORCC as RBC Capital Markets analyst Kenneth Lee and Janney analyst Michael Penn recently upgraded Owl Rock Capital to outperform and buy.
For those investors who understood the undervalued premium portfolio that Owl Rock Capital has been building in ORCC, they saw 35% returns from Q1 2020 to Q4 2020. The company has a solid dividend moving forward and a conservative bright equity upside story as well; as CEO Craig Packer and COO Alan Kirshenbaum, drive the company toward a portfolio value of $11.5B generating a total investment income of $1B annually investors can rest assured that their dividend will be secure and growing.
This article was written by
Analyst’s Disclosure: I am/we are long ORCC. 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.
The content of this post is not meant as investment advice as it is the expressed opinion of the author. The numbers and statistics were developed using public information from involved companies and may as all analyst work contain errors. Any decisions or actions made by readers or actors of this article are the sole responsibility of the readers or actors themselves and have no legal or financial responsibility or bearing on the author.
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