The negative impacts of COVID-19 have been particularly pronounced for many Business Development Companies (“BDCs”). Owl Rock Capital Corp (ORCC) is one example where the share price has been pushed lower and the dividend yield has mathematically risen to over 10% (over 12.5% if you count the recently declared special dividend). Owl Rock’s strong liquidity position will help it whether the current storm and take on attractive new opportunities once it has addressed the most pressing liquidity needs of its existing portfolio companies. This article reviews the health of Owl Rock’s business, valuation, risks, dividend safety, and concludes with our opinion about why it may be worth considering if you are a long-term income-focused investor.
Owl Rock (ORCC) Share Price:
Overview:
Owl Rock is an externally-managed business development company (“BDC”) primarily focused on providing debt financing to middle market companies (revenue between $50 million-$2.5 billion) in the US. It is the second largest publicly traded BDC with total AUM of ~$8.9 billion as of Q120. ORCC’s portfolio is highly diversified across 101 companies with senior secured (first & second lien) accounting for ~98% of total investments. High exposure to senior secured debt is important, especial during the current pandemic, because it increases safety versus the subordinated debt of its portfolio companies.
The average investment size of an ORCC portfolio company is ~$88 million. ORCC's portfolio is more diverse than its peer average, with the top 10 investments accounting for ~24% of the portfolio at Q120, thereby limiting loss exposure to any individual investment. In fact, no single borrower accounts for more than 3% of the portfolio at fair value. The portfolio is well diversified by industry as well, with the top 6 industries representing just 46% of the portfolio and the single largest industry accounting for just 8.6% at fair value.
(source: Company Presentation)
Relatively Defensive Sector Exposures:
As you can see in the figure above, ORCC’s six largest sectors are software, professional services, insurance, healthcare providers, distribution, and food and beverage, which collectively comprise ~46% of the portfolio. All of these are defensive and will likely hold up better than many other sectors. Software investments (8.6% of the portfolio) often have high recurring revenue and are very resilient in economic downturns. Similarly, Insurance (7.9% of the portfolio) and Professional Services (8.1% of portfolio) have been relatively less scathed during this crisis. Plus, the Distribution businesses (at ~7% of the portfolio) have been classified as essential and continue to operate.
To its benefit, Owl Rock has only modest exposure to the sectors that have been most impacted. For example, oil and gas and leisure & entertainment (combined) represent only 4% of the portfolio. Further Owl Rock has no direct exposure to travel and hospitality. We think Owl Rock’s focus on selecting defensively positioned companies in less cyclical sectors gives it an advantage over many of its peers in the current environment.
Owl Rock noted the following during its recent Q1-20 earnings call:
“We believe we entered this unique period in a position of relative strength. Our portfolio consists primarily of first-lien term loans to upper middle market businesses with an average EBITDA of $83 million. We try to assemble our portfolio in a defensive-minded manner by focusing on large, stable, recession-resistant businesses.”
Weathering the COVID Storm
Importantly, the average loan-to-value of ORCC’s investments is approximately 50%. This means, on average, the companies could lose 50% of their value, and still not be impaired.
While the COVID-19 crisis is affecting businesses across industries, ORCC noted that so far (at least through Q1), the impact on its portfolio companies has been low. ORCC has downgraded only 4.8% of its total loans to high-risk category (internal rating of 4). ORCC defines rating 4 as a loan where the risk has increased materially since origination. 88% of its holdings were in the top two tiers (Rating 1 and 2), meaning the loans are performing as per or better than expectations.
(source: Company Presentation)
We like the fact that many of its portfolio companies already have financial sponsors (backed by private equity) that can provide financial and operational support, which can help them weather the current market challenges and preserve their long-term value.
Craig Packer, ORCC’s CEO noted during Q1 earnings call:
“roughly two-thirds of our sponsor-backed portfolio companies are owned in private equity funds with either permanent capital or relatively recent vintages, generally in funds that have closed in the last four years, and that these investments tend to benefit from the dry powder available in these funds, meaning that sponsors have both the motivation and the ability to continue to provide financial support to these portfolio companies.”
Conservative, Well Capitalized Balance Sheet
ORCC maintains a conservative capital structure, with limited overall leverage and low cost long-term debt. For example, ORCC’s net debt to equity ratio as of Q1 was 0.60, which is the lowest among its peers. ORCC has four “investment grade” credit ratings, and none of the outlooks have been changed throughout the current crisis. ORCC’s weighted average debt maturity is over 5.5 years, and the compnay has no debt maturities until December 2022. This puts ORCC in a robust liquidity position that also includes $2.0 billion of cash and undrawn debt capacity. For perspective, this compares to approximately $0.5 billion in undrawn commitments to its portfolio companies (i.e. ORCC has enough liquidity to fund all of its undrawn commitments by over 3.5x). This strong liquidity position will also allow ORCC to continue to support our existing borrowers and selectively deploy capital in additional investment opportunities.
Compelling 10% Dividend Yield
Owl Rock has maintained a solid dividend payout since is IPO in July 2019. The company recently declared a $0.31 dividend for Q2, with an additional special dividend of $0.08 (bringing the total quarterly distribution to $0.39). This equates to a dividend yield of 10% (or 12.5% if you count the special dividend).
We estimate that ORCC's 2019 net investment income (NII) dividend coverage (excluding special dividends) was 110.8% in 2019 (and 107.5% if you include special dividends). However, NII fell to $0.37 in Q1, whixh covers the ordinary dividend, but not the special dividend. And considering the ongoing economic impacts of the pandemic, dividend coverage could decline further. However, we believe ORCC’s low leverage provides additional cushion. Specifically, the company’s leverage of just 0.6x is well below its target of 0.75x (and offers flexibility to raise cash to fund any dividend shortfall). Also very important, on April 1st Owl Rock announced that its Board of Directors unanimously approved a reduction of the Company’s minimum asset coverage ratio from 200% to 150%. Once effective, Owl Rock plans to target a debt-to-equity range of 0.9 times to 1.25 times, which would allow the business to operate with an increased cushion. Further still, ORCC plans to further increase its target leverage range to 0.9-1.25x, which will provide additional liquidity. And while this may give some investors pause, we believe the dividend can be maintained throughout this pandemic, considering Owl Rock’s significant balance sheet flexibility.
(source: Company Presentation)
Valuation:
Owl Rock ended the first quarter with a net asset value of $14.09 per share, down 7.5% versus the prior quarter, and this primarily reflects the unrealized losses across the portfolio resulting from the significant spread widening that occurred in the market at the end of the quarter (i.e. spread widening is an input in the investment valuation process for Owl Rock).
However, Owl Rock’s CEO noted the following on the quarterly call:
“Since quarter end, we have seen market spreads tighten, which if sustained will increase the value of our portfolio. However, what ultimately matters most is getting repaid on our loans at par.”
With regards to valuation, Owl Rock’s historical Price to Book ratio has typically been in a range of 1.0x to 1.2x, since its IPO in July 2019. However, the COVID-19 sell-off pushed it lower, almost to 0.5x in late March. It has since rebounded, and is current trading at ~0.87x, which still represents a discount versus NAV and a discount versus history. In our view, based on the risk-reward tradeoff, we view this as attractive, and it gives investors an opportunity to “buy low.” We believe Owl Rocks has enough liquidity to get through this crisis and emerge stronger on the other side.
Notably, CEO Craig Packer made a large open market purchase of ORCC shares on May 7th. Specifically, he bought 75,750 shares at $13.17, for a total of ~$1 million. This is encouraging to see, and considering the current share price, investors have an opportunity to purchase at even a lower price than the CEO.
Also worth mentioning, investors should be aware of Owl Rocks ongoing equity offerings and share repurchases.
(source: Company Presentation)
According to Owl Rock’s most recent quarterly call:
“We got a lot of questions on the share buyback during this period of time. It should have been that uncertain because as we had said at the time of the IPO, this was a programmatic buyback, that was taking place as long as the stock traded a penny below NAV.
We didn’t disclose the amount, but, it was very clear from our disclosure that any day that the shares are trading a penny below NAV that the buyback would be in place. So there was nothing aggressive or not aggressive about it, it was just mathematical based on shares that were trading on days that the stock was trading a penny below NAV.
As you know, most of this period of time since our IPO, that has not been the case, but with the recent market disruption it probably been the case. And so the buyback has been operational. We haven’t disclosed the formula, but I can share that the program, the regulatory program that it operates under has a cap on any given day of 25%.”
Post-Crisis Opportunities:
Important to note, Owl Rock is currently focused on protecting its balance sheet and ensuring prudent liquidity for portfolio companies as they worth through this pandemic. However, once there is more clarity around the needs of portfolio companies, Owl Rock is well positioned (from a liquidity standpoint) to take advantage of attractive market dislocation opportunities that other lenders cannot (again due to liquidity constraints). Notable, during the quarterly call it was revealed by Owl Rock that:
“We also continue to add to our workout capabilities. In April, we brought on board a new Head of Workout who previously held this role at another direct lender. With more than 55 experienced investment and portfolio management, professionals, many of who have spent years in the direct lending space and have experience investing through a credit cycle.
However, the nature of the economic shutdown has created pressure on many companies needs for near-term liquidity. So we are focused on that for each of our borrowers.
Our focus right now has shifted to primarily preserving significant capital to support our borrowers should they need it, so that we can protect the value of our investments.”
However, management also explained (and this is encouraging, in our view):
As we gain better confidence around the needs of our portfolio companies, we believe we will eventually be able to shift our focus more towards new investment opportunities. Given the market disruption, we believe these new opportunities will offer very attractive economics, company packages and structural protections.
Also worth noting (and this is a good thing for Owl Rock’s investments going forward, especially considering current market dislocation):
“I would note that we have a significant amount of high quality, but lower spread first lien term loans in our portfolio that are currently at a spread of L plus 500 or less, which as we paid would provide an opportunity for increased spreads.”
Owl Rock is well positioned to take advantage of attractive opportunities going forward, as CEO Craig Packer explained during the call:
“As the economy eventually recovers from this crisis, we believe, we are well positioned to take market share and to emerge and improve market position.”
Risks:
Underwriting risk: Owl Rock primarily invests in debt instruments of middle-market companies which makes its inherently risky (as evident from their higher yields, and the fact that these are the type of investments that are often too risky for traditional banks to take on). Thus, Owl Rock is exposed to significant underwriting risk. Any poor underwriting decision by Owl Rock, could lead to heavy losses in its portfolio (however, we appreciate the well-diversified nature of Owl Rock’s portfolio).
Recession risk: BDC’s are often vulnerable to recessions considering that they provide financing to middle market companies which are less established and prone to defaults. And considering the ongoing COVID-19 crisis, if prolonged, it could cause a deep recession and significant challenges for Owl Rock’s business.
Low interest rates: are a risk factor for Owl Rock considering the potential negative impact on investment income. Specifically, the majority of Owl Rock’s portfolio investments have yields tied to floating market interest rates (such as LIBOR). At the same time, a large portion of Owl Rock’s own liabilities are fixed (i.e. they don’t see a commensurate decline versus the floating rates portfolio companies). As a result, a rapid decline in interest rates (which seems quite unlikely given the Fed's near zero policy) can lead to a compression in Owl Rock’s net interest margins.
Conclusion:
Owl Rock will be impacted negatively by the coronavirus, and the full extent of those impacts is not yet know. However, the share price has declined dramatically (-31% YTD) and the valuation is particularly attractive relative to history and other BDCs. Further, Owl Rock is different that many other BDCs because it is in a strong liquidity position to weather coronavirus challenges, and will likely be in a strong position to take advantage of distressed market opportunities in the coming quarters (i.e. providing financing to companies at attractive rates that will be beneficial to ORCC shareholders). If you are a contrarian income-focused investor, Owl Rock’s big dividend is worth considering for a spot in your portfolio.