As every good financial professional knows, you need rock or stone in your name to be ultra successful. If you don’t believe me, ask the world’s largest asset manager, BlackRock (BLK), or Blackstone Group (BX). They’ll tell you.
Owl Rock’s origins are derived from the credit divisions of Blackstone, Goldman Sachs (GS), and KKR (KKR). The firm has come a long way in its short lifespan beginning in 2016. Management’s tenure at the highest echelon of credit managers has allowed them to do two things: build the first credit company of its type to suffer no realized loan losses to date and invest personal capital to the tune of well over $100 million alongside investors. That’s a powerful combination and it has not gone unnoticed.
We’ve written on Owl Rock and its publicly traded BDC (ORCC) several times. In fact, WER was the first to author a public article on ORCC and Bain Capital Specialty Finance (BCSF) after each had their initial public offering. This wasn’t coincidence; we’d performed institutional due diligence on both organizations and their private vehicles that later became publicly traded. We included ORCC in numerous “BDC Battles” so readers have a better understanding of what makes each “Tier 1” BDC unique.
ORCC earned its spot in the Crisis IIP Portfolio as well as its maximum quality ranking of 5 out of 5. This article will reiterate why that’s the case and provide a detailed portfolio breakdown. Like our recent article and Editor’s Pick on Ares Capital (ARCC), we will leave no stone (or rock) unturned.
Owl Rock Strategy & Portfolio
In many ways, ORCC’s strategy mimics what we are used to: primarily first and second-lien, floating rate, senior secured loans. Where Owl Rock differs from other BDCs is its concentration on and ability to take down very large loans. Owl Rock had the foresight to see the trend of gigantic private companies well before the crowd. Hundred billion dollar valuations on tech companies like Uber (UBER) were exceedingly rare when Owl Rock got started in 2016.
For the few portfolio managers and analysts that take the time to do so, the public filings of each of Owl Rock’s BDCs tell an interesting tale: with few exceptions, they all participate in each loan opportunity. If those same individuals take an even closer look, they’ll see that the board members across the Owl Rock platform are identical. This makes sense as it permits Owl Rock’s funds to function as a single buyer.
ORCC alone has $9.2 billion in assets as of the last reporting date, making it one of the top three BDCs by AUM. Add in ORCC II’s $1.5 billion in total assets and the other Owl Rock vehicles, and there is at least $12.0 billion in private credit assets under management (“AUM”) behind the Owl Rock name. By allocating large loans across multiple vehicles, Owl Rock can take down big loans responsibly in a manner few others can.
Source: Q4 Earnings Release
As of the end of 2019, the portfolio had 98 portfolio companies with 5.5x EBITDA to net debt on average. Despite the large aggregate loan values, they are digestible for each Owl Rock entity.
Source: Owl Rock Capital Corporation Q4 Earnings Release
Top 10 holdings are less than 25% of the portfolio. We all recognize how critical industry exposure is in today’s environment. Ares’ number one sector was healthcare then technology. In Owl Rock’s case, its number one and two industries are Distribution and Healthcare Providers and services. That’s correct, while most of the western world is ordering everything online and quarantined due to a literal pandemic, Owl Rock’s #1 and #2 industry exposures are Distribution and Healthcare providers and services.
That’s not the entire portfolio so let’s keep working down the list. Right behind those at #3 is Technology Services, another area perfectly suited to combat the current crisis. Professional services at #4 is a broad category with mixed economic sensitivity, but #5, Food and Beverage, is another durable segment. Buildings and Real Estate should perform well in the medium- to long-term but may see write-downs in the interim as cash flow projections morph into a font size 72 question mark. Continuing down the list, #7 Insurance should manage as will #10, Healthcare technology. #8 Business Services and #9 Education, like Professional Services, will likely include winners and losers. These industries represent over two-thirds of the portfolio (68.2%) so we’ll stop here and reserve the remaining for the scenario analysis later in the article.
Source: Owl Rock Capital Corporation Q4 Earnings Release
Owl Rock’s loans are clearly at the top of the capital structure and essentially all first and second lien loans.
Source: Owl Rock Capital Corporation Q4 Earnings Release
Trends are among the most important yet most overlooked aspects of investing in general and BDCs in particular. Owl Rock’s industry concentrations are not the only attributes of the portfolio well suited for today’s crisis. 100% of Q4 2019’s new investment activity was first lien senior secured loans. Effectively all (>99.5%) of 2019’s new investment activity was first and second lien originations. The portfolio’s exposure to equity, subordinated, mezzanine, or any asset type outside of first and second lien loans is <1.0%. Owl Rock builds their portfolios assuming black swan events will occur randomly.
Source: Owl Rock Capital Corporation Q4 Earnings Release
Outside of a few sectors, such as retail and upstream oil and gas, markets have been normal in the past few years. As a result, Owl Rock’s “bunker-style” portfolio has experienced zero realized losses. As of the end of 2019, the firm had zero loans classified in the lower two performance ratings as shown above. As we’ve said many times, management has significant discretion on how investments are classified. What they can’t manipulate are non-accruals and interest payments. Thus far in ORCC’s public and private life, its track record is perfect.
The portfolio is well diversified, concentrated at the top of the capital structure, industry exposures are as if management knew the coronavirus was going to wreck the economy, and ORCC’s non-accrual track record is spotless. As keen investors, that means we can direct our attention toward the next component of our analysis.
Owl Rock Balance Sheet & Liquidity
Source: Owl Rock Capital Corporation Q4 Earnings Release
We mentioned in the Ares article that management publicly noted it had already extended additional credit to some borrowers and that it has sufficient liquidity to meet the needs of both its borrowers and lenders. Since then, two other positive press releases were made concerning its liquidity:
Ares Capital increases and extends its revolving credit facility
Ares Capital upsizes revolving credit facility to $3.6B
Owl Rock is also favorably positioned with $3.09 billion in liquidity or 60% of its total outstanding debt for context. Owl Rock just recently announced relaxed leverage constraints in line with peers. We much prefer that Owl Rock increase its leverage during downturns than when assets are priced for perfection. There is no reason to overreact to this announcement as no changes to Owl Rock’s underwriting standards are expected.
Like most top quality firms we’ve evaluated for admittance into the Crisis IIP Portfolio, ORCC has no debt maturing in 2020 or 2021. Even its debt liabilities in 2022 and 2023 are modest at ~11% of total assets. Despite its short lifetime as a publicly traded company, ORCC (Baa3, the lowest rung of investment grade) and its unsecured notes have earned favorable credit ratings from major agencies.
Like Ares, Owl Rock has confirmed its liquidity position publicly in recent days.
Source: Owl Rock Capital Corporation Q4 Earnings Release
ORCC’s leverage profile is the most conservative in the entire BDC sector and by a wide margin. This is in part because ORCC could call equity capital from previous private investors as needed rather than rely on issuing debt or additional shares of common stock. ORCC ended 2019 with a debt-to-equity ratio of only 0.46x. That’s half of ARCC’s 0.93x which itself is in the bottom 25% of the sector. Seeking Alpha darling Main Street Capital Corporation (MAIN) ended 2019 with a net debt to equity ratio of 0.73x for additional context. From a leverage standpoint, ORCC is in a league of its own. The fact it is able to pay a competitive distribution with such low levels of leverage is impressive.
Though a relatively new BDC, ORCC has covered its distribution with net investment income every quarter since its inception (Q2 2019 included a special distribution connected to previous quarters. The regular distribution was fully covered). The exact figures are provided in the above table.
This conservative profile will pay dividends in the scenario analysis section.
Owl Rock Distribution
Source: Owl Rock Capital Corporation Q4 Earnings Release
Owl Rock’s portfolio mechanics permit substantial clarity in the cash flow available for distributions including in the future. The Board of Directors has already approved major components of 2020’s complete distribution schedule and amounts. Without getting into unnecessary detail, BDCs pay their distributions through a combination of income and capital gains. BDC management is not required to pay all undistributed gains to shareholders but better companies tend to. ORCC’s Board has spread out its various forms of income in 2020 via quarterly regular and special distributions of $0.31 and $0.08, respectively.
Not to state the obvious, but these numbers may change due to the ongoing crisis. It’s likely most of these distributions will be paid even with a prolonged government-mandated shutdown meaning a double-digit cash yield at the current stock price is highly probable. There aren’t many BDCs, or companies in the S&P 500, that statement applies to. In aggregate, 2020’s anticipated distributions of $1.56 equate to a 14.9% yield at the stock price of $10.50 at the time this article was written.
Share Lock-ups
As noted in our previous articles, Owl Rock was previously a private institutional offering subject to capital calls. It also restricted the ability for existing shareholders to sell shares once the IPO occurred. This was designed to support ORCC’s share price while providing liquidity to the original investors. We’ll save you the fine print and provide a useful summary directly from the 10-K instead:
For 180 days, a shareholder is not permitted to … dispose of or encumber any shares of common stock held by such shareholder prior to the date of the IPO.
For 270 days, a shareholder is not permitted to … dispose of or encumber two-thirds of the shares of common stock held by such shareholder prior to the date of the IPO.
For 365 days, a shareholder is not permitted to … dispose of or encumber one third of the shares of common stock held by such shareholder prior to the IPO.
These three restrictions correspond to January 14th, April 13th, and July 17th of this year. Management voluntarily agreed to a longer mandatory hold period:
…the Adviser, our directors and Mr. Lipschultz have agreed for a period of 540 days after the IPO and we and our executive officers who are not directors have agreed for a period of 180 days after the IPO, (I) not to offer, sell, contract to sell, pledge, grant any option to purchase, lend or otherwise dispose of, or file with the SEC a registration statement under the Securities Act (other than a registration statement pursuant to Rule 415 of the Securities Act) relating to, any shares of our common stock…
Management has tens of millions of dollars of their own capital invested in ORCC so this is a meaningful commitment.
Owl Rock Share Repurchase Plan
Earlier in 2020, ORCC issued a press release concerning the $150 million share repurchase plan. In short, and as noted in the financial statements, a third party (Goldman) implements the share repurchase plan using a pre-determined system.
While the minute details are not public, this information is: the $150 million buyback plan is triggered when the stock trades below Net Asset Value as of the last reporting period. The farther the stock trades below that point, the more daily shares are repurchased up to a daily limit of ~1/3 recent average trading volumes.
That’s only 3.3% of the current market capitalization but every bit helps when the stock price is severely distressed.
Scenario Analysis
We’re going to take a similar approach to our article on Ares. Since ORCC wasn’t around during the Great Recession, let’s see the impact of the same hit we envisioned for Ares: double its 2.0% realized loan losses.
Source: SEC.gov ORCC 2019 10-K
ORCC’s most recent net asset value per share (“NAVPS”) was $15.24 and has remained stable going back to its private offering days. There were 324,630,279 shares outstanding as of the end of last years so the firm’s net equity was $4.95 billion. Reducing the $8.8 billion in total assets by 4.0% results in $352 million in loan losses or a firm value of $4.598 billion.
The new BVPS is $14.16 or 7.1% lower than December 31, 2019’s value. ORCC has historically traded at a 7.5% to 14% premium to NAV, but we’ll ignore that for now. Compared to today’s close of $11.50, doubling Ares’ loss ratio in the Great Recession still results in the stock trading a 23% discount.
Next, we’ll discount the portfolio by industry.
Source: SEC.gov ORCC 2019 10-K & Williams Equity Research
We created this chart from the 10-K and added two columns on the right. We discounted loans associated with Professional Services, Manufacturing, Specialty Retail, Oil and Gas, Leisure and entertainment, and Energy equipment and services by 50%. This equates to asset value losses of over two-thirds for the associated portfolio companies. We then wrote down loan values in Buildings and real estate, Business services, Education, Aerospace and defense, Infrastructure and environmental services, Advertising and media, and Automotive by 33%. Again, loan losses of 33% mean much greater equity losses.
Applying this apocalyptic scenario reduces total assets by 26.4% resulting in $2.32 billion in realized loan losses or a BVPS of $8.09. This corresponds to 13.2 times more loan losses than Ares experienced during the Great Recession.
Take a look at ORCC’s 52-week lows highlighted in green:
Source: Seeking Alpha
In a sense, the scenario we identified perfectly matches the market’s sentiment and expectations on ORCC’s darkest day.
Last but not least, we’ll apply the capital structure scenario analysis. We’ll round equity and all other subordinated positions up to 1.0% of the portfolio while discounting the first and lien loans by 10%. As a final remainder, this means all equity is erased out and only 90% of the most secure loans are repaid. Adding the $8.8 million in equity/subordinated losses to the $871.2 million charge to first and second lien loans equates to a NAVPS of $12.53 and prices in over 5 times greater loan losses than Ares experienced during the Great Recession. This is the closest yet to the current share price.
Conclusion
Given the trading history of BDCs like Main Street, Golub (GBDC), and Ares Capital, ORCC will likely earn a premium to NAVPS of 10-20% as markets normalize.
This puts our conservative sell target above $15.0 assuming 1) the lower range of premium to NAVPS and 2) realized loan losses approximately three times worse than Ares and other high quality BDCs experienced during the Great Recession. $15.00 is 35-40% lower than today’s value, but the cash yield boosts annualized returns substantially.
On the buy side, ORCC is up ~26% from its 52-week lows (a couple days ago it was >40%), but that cannot be our focus. We must concentrate on acting on good opportunities and not evaluate decisions using hindsight. A great entry point on a great company does not change depending on where the stock trades in the future. This is controversial but nonetheless fact. Though we reserve our crisis buy range for subscribers, we are now within this range. As always, we suggest buying in tranches to avoid heavily weighting market timing. Most investors will find layering bids evenly within the price range to work very well in most cases. That’s what WER’s portfolio managers do with their personal investments.
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Disclosure: I am/we are long MAIN, GBDC, GS, ARCC. 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.
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