Fitch Revises Oaktree Specialty Lending Corporation's Outlook to Negative; Affirms IDR at 'BBB-'

Published: 2025-05-08 09:38:12 ET OCSL

Published on 05/08/2025 at 09:38

Fitch Ratings has affirmed Oaktree Specialty Lending Corporation's (OCSL) Long-Term Issuer Default Rating (IDR) and senior unsecured debt at 'BBB-'. Fitch has also affirmed OCSL's senior secured debt rating at 'BBB'.

The Rating Outlook has been revised to Negative from Stable.

Key Rating Drivers

Deteriorating Asset Quality Metrics: The Outlook revision reflects meaningful deterioration in OCSL's asset quality as evidenced by elevated non-accrual levels and above-average realized loss rates in recent quarters. The Negative Outlook also reflects OCSL's weak cash earnings coverage of dividends.

In the year ended Dec. 31, 2024, net realized losses (adjusted for merger accounting impacts) were 4.9% of the average portfolio at fair value, which was above the rated business development company (BDC) peer average of losses of 1% and outside of Fitch's 'bbb' category benchmark range of 2% to -3%. Non-accrual investments have risen steadily in recent quarters and amounted to 8.1% and 4.9% of the debt portfolio at cost and fair value at March 31, 2025 (fiscal 2Q25), respectively. This was well above the rated peer averages as of Dec. 31, 2024. Unrealized losses have also increased and amounted to 2.9% of the beginning portfolio in fiscal 2Q25, resulting in the portfolio being marked at 92.9% of cost at quarter-end.

Fitch believes elevated non-accruals will drive additional realized losses for OCSL in 2025 as investments are restructured. A downgrade could result from significant realized credit losses and persistently elevated non-accrual levels.

Platform Affiliation Benefits: OCSL's ratings continue to reflect its affiliation with Oaktree Fund Advisors, senior secured investment focus, appropriate asset coverage cushion, and solid funding flexibility. In February 2025, the company's investment advisor announced that they would purchase $100 million of OCSL's stock at 1.0x net asset value, a premium to where the shares were trading, which will help grow OCSL's asset base and further diversify the portfolio. However, Fitch will carefully monitor any significant near-term growth given the very competitive underwriting environment.

Above Average Losses: Rating constraints include OCSL's elevated realized losses during 2024 and the recent increase in non-accruals, which could result in additional net realized losses in 2025. Additional constraints include the higher-than-peer exposure to nonqualifying assets and weak cash earnings coverage of the dividend.

Sector Constraints: Rating constraints for BDCs include the market impact on leverage, given the need to fair-value the portfolio quarterly, dependence on access to the capital markets to fund growth and a limited ability to retain capital given distribution requirements. Fitch believes BDCs will face a competitive underwriting environment, weaker earnings and dividend coverage metrics due to recent rate cuts, tighter spreads and a slower M&A environment, and further deterioration in asset quality metrics in 2025.

Weakening Dividend Coverage: In fiscal 1H25, OCSL's adjusted net investment income (NII) coverage of regular dividends declared was 103.7%. Coverage was meaningfully weaker, at 83.2%, when adjusted for non-cash interest income and expenses, which is below the peer average.

Payment-in-kind (PIK) income increased year-over-year to 6.3% of interest and dividend income, although remains below the rated peer average. OCSL cut the regular dividend in 1Q25, to $0.40 per share and introduced a supplemental dividend framework, which should benefit dividend coverage in coming quarters. Fitch views the dividend cut as prudent. Failure to improve cash earnings coverage of the dividend could result in a rating downgrade.

Solid Liquidity: As of fiscal 2Q25, OCSL had $97.8 million of cash and $1.1 billion of borrowing capacity on its secured credit facilities. This was sufficient relative to unfunded lending commitments of $299.8 million. In February 2025, OCSL issued $300 million of unsecured notes due in 2030 and repaid $300 million of unsecured notes due in February 2025. OCSL's next unsecured debt maturity is in January 2027 when $350 million of notes come due. Unsecured debt amounted to 64.6% of OCSL's outstanding debt at fiscal 2Q25, within Fitch's 'bbb' category benchmark range of 35%-100%.

Losses Could Impact Asset Coverage: As of March 31, 2025, leverage (par debt-to-equity) was 1.00x, within OCSL's 0.9x-1.25x target and down from 1.12x at fiscal 1Q25 due to elevated repayments during the quarter. Leverage implied an asset coverage cushion of 25.1%, within Fitch's 'bbb' category benchmark range of 11%-33%. Fitch views the increase in the asset coverage cushion favorably given recent credit deterioration. Failure to maintain sufficient asset coverage cushion for potential realized and unrealized losses, in the face of elevated non-accruals, would result in a rating downgrade.

Potential Pressure on Yields: NII, adjusted for the purchase accounting discount amortization, amounted to 5.3% of the average portfolio at cost in in fiscal 1H25, annualized, which was below 5.7% a year prior. Fitch believes OCSL's NII will face pressure from lower investment yield, higher non-accruals, and increased interest expense from the increased funding cost from the recent bond refinancing, but the recently lowered management fee to 1% of gross assets and incentive fee credit lookback waiver will offset some of the earnings pressure.

RATING SENSITIVITIES

Factors that Could, Individually or Collectively, Lead to Negative Rating Action/Downgrade

Further deterioration in non-accrual levels and/or meaningful realized;

An inability to improve cash-based NII coverage of the dividend approaching 100%;

An inability to maintain an asset coverage cushion sufficient for the risk profile of the portfolio and potential realized and unrealized credit losses;

Failure to maintain a sufficient liquidity cushion for unfunded commitments and operating needs;

A sustained decline in the unsecured funding mix below 35% of total debt outstanding; and/or

An elevation in the portfolio risk profile, including a material decline in first lien loans as a percentage of the portfolio.

Factors that Could, Individually or Collectively, Lead to Positive Rating Action/Upgrade

A revision of the Outlook back to Stable could result from a material decline in non-accrual levels without the recognition of meaningful realized losses. A revision to Stable would also be conditioned upon maintenance of leverage within the targeted range, improved cash earnings dividend coverage, sufficient liquidity and unsecured debt of at least 35% of total debt.

Positive rating momentum is limited over the near term given the recent deterioration in credit metrics. Factors that could, individually or collectively, lead to positive rating action/upgrade over time include:

Unsecured debt being maintained at or above 40% of total debt outstanding;

The maintenance of sufficient liquidity;

Maintenance of leverage commensurate with the portfolio risk profile; and/or

Stronger cash earnings coverage of the dividend.

DEBT AND OTHER INSTRUMENT RATINGS: KEY RATING DRIVERS

The senior secured debt rating of 'BBB', which is one-notch above OCSL's Long-Term IDR, reflects Fitch's view of good recovery prospects in a stress scenario given its funding mix and available asset coverage.

The alignment of the expected senior unsecured debt rating with the Long-Term IDR reflects average recovery prospects under a stress scenario since OCSL is subject to a 150% regulatory asset coverage requirement.

DEBT AND OTHER INSTRUMENT RATINGS: RATING SENSITIVITIES

The secured and unsecured debt ratings are primarily linked to the Long-Term IDR and are expected to move in tandem with it. However, a material reduction in unsecured debt as a proportion of total debt could result in the unsecured debt rating being notched down from the IDR.

ADJUSTMENTS

The Standalone Credit Profile (SCP) has been assigned in line with the implied SCP.

The Asset Quality score has been assigned below the implied score due to the following adjustment reasons: Concentrations; asset performance (negative) and Historical and future metrics (negative).

The Funding, Liquidity & Coverage score has been assigned below the implied score due to the following adjustment reason: Funding flexibility (negative).

Sources of Information

The principal sources of information used in the analysis are described in the Applicable Criteria.

REFERENCES FOR SUBSTANTIALLY MATERIAL SOURCE CITED AS KEY DRIVER OF RATING

The principal sources of information used in the analysis are described in the Applicable Criteria.

ESG Considerations

The highest level of ESG credit relevance is a score of '3', unless otherwise disclosed in this section. A score of '3' means ESG issues are credit-neutral or have only a minimal credit impact on the entity, either due to their nature or the way in which they are being managed by the entity. Fitch's ESG Relevance Scores are not inputs in the rating process; they are an observation on the relevance and materiality of ESG factors in the rating decision. For more information on Fitch's ESG Relevance Scores, visithttps://www.fitchratings.com/topics/esg/products#esg-relevance-scores.