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

The Rating Outlook is Stable.

The 'A-' Long-Term IDR and Stable Outlook assigned to Oaktree Capital Group, LLC (collectively with the Oaktree Operating Group entities, Oaktree), the parent company of OCSL's external manager, Oaktree Fund Advisors, LLC (Oaktree Fund Advisors), are unaffected by these actions.

Today's rating actions have been taken as part of a broader review of business development companies (BDCs) which included 18 publicly rated firms. For more information on the peer review, please refer to 'Fitch Ratings Completes 2023 BDC Peer Review,' available at www.fitchratings.com.

Key Rating Drivers

The ratings affirmation reflects OCSL's access to investment resources from Oaktree Fund Advisors, focus on senior debt investments, solid asset quality metrics and appropriate asset coverage cushion.

Rating constraints include the recent decline in the unsecured funding mix; higher-than-peer exposure to nonqualifying assets; and above-average, albeit declining, exposure to broadly syndicated loans which can result in higher valuation volatility.

Rating constraints for BDCs more broadly 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 due to distribution requirements. Additionally, Fitch believes BDCs will experience weaker asset quality metrics in 2023 amid higher interest rates and slower growth at portfolio companies.

OCSL's asset quality metrics have been strong in recent years, as demonstrated by the generation of net realized gains on investments in three of the last four fiscal years, including the year ended Sept. 30, 2022 (fiscal 2022). Fitch expects non-accruals will tick up in 2023 given higher debt service burdens for borrowers but believes OCSL's credit performance will remain above-average since the firm did not have any investments on non-accrual status at Dec. 31, 2022 (fiscal 1Q23). OCSL's portfolio weighted average interest coverage was 2.5x at fiscal 1Q23, which is above-average, but definitions vary across the sector.

OCSL's net investment income (NII) yield, defined as adjusted NII (adjusting for capital gains incentive fee accruals not paid in cash and merger accounting impacts) as a percentage of the average portfolio at cost, was 5% in fiscal 2022, up from 4.5% in fiscal 2021 driven by rising interest rates and continued rotation out of lower-yielding investments. The adjusted NII yield improved to 5.5% (annualized) in fiscal 1Q23. Fitch believes there is additional upside to OCSL's earnings given benefits from higher interest rates and continued rotation out of lower-yielding investments, but funding costs will also increase since 80.1% of OCSL's outstanding debt (adjusted for interest rate swaps) was floating-rate at fiscal 1Q23.

In August 2022, OCSL announced an increase in its target leverage range to 0.9x-1.25x, up from 0.85x-1.00x previously. Fitch views OCSL's new target leverage range, which is in line with most rated BDCs, as appropriate for its portfolio risk profile. At Dec. 31, 2022, OCSL's leverage (par debt-to-equity) was 1.26x (1.24x net of cash), but declined to 1.18x (1.16x net of cash) pro forma for the merger with Oaktree Strategic Income II, Inc. (OSI II), which closed on Jan. 23, 2023.The pro forma leverage level provides OCSL with incremental capacity to take advantage of new origination activity in 2023, which could be a competitive advantage should terms on new deals remain more lender-friendly than in prior years.

The leverage ratio implied a Fitch-calculated asset coverage cushion of 16.5% at fiscal 1Q23, or 18.9% pro forma for the merger, within Fitch's 'bbb' category capitalization and leverage benchmark range of 11%-33%. Fitch expects OCSL to continue to manage the covenant cushion at an appropriate level to account for potential investment valuation volatility and/or future credit losses.

Unsecured debt accounted for 43% of OCSL's outstanding debt at fiscal 1Q23, but declined to 36% pro forma for the OSI II merger, which was at the low end of Fitch's 'bbb' category quantitative benchmark range of 35%-50% for BDCs. OCSL's next unsecured debt maturity is in February 2025, but drawing on secured facilities to fund portfolio growth could further pressure the unsecured debt ratio. Fitch believes OCSL will seek to issue additional unsecured debt to maintain unsecured debt-to-total debt of at least 35%, but market conditions could remain more challenging in 2023. A sustained decline in unsecured debt below 35% of total debt would be viewed negatively.

After-tax adjusted NII coverage of dividends declared, excluding special dividends, amounted to 108.4% in fiscal 2022 and 112.3% in fiscal 1Q23. Adjusting for non-cash income and expenses, Fitch estimates dividend coverage was 79.8% in fiscal 2022 and 86.5% in fiscal 1Q23. Paid-in-kind (PIK) income represented 8.4% of interest and dividend income in fiscal 2022 and 8.1% in fiscal 1Q23. Fitch believes PIK income could tick up in 2023 as a result of amendment activity and will continue to monitor OCSL's ability to collect PIK in cash over time.

The Stable Outlook reflects Fitch's expectations that OCSL will continue to demonstrate solid asset quality metrics, focus on senior debt investments, manage leverage within the targeted range, maintain unsecured debt-to-total debt of at least 35%, and maintain sufficient liquidity and solid dividend coverage.

Rating Sensitivities

Factors that could, individually or collectively, lead to negative rating action/downgrade:

A sustained meaningful increase in non-accrual levels and/or realized losses, a sustained increase in leverage above the targeted range, a sustained decline in unsecured debt to below 35% of total debt outstanding and/or weaker cash-based NII coverage of the dividend.

Factors that could, individually or collectively, lead to positive rating action/upgrade:

Strong and differentiated credit performance of recent vintages, evaluated in combination with the consistency of OCSL's operating performance, asset quality metrics, investment valuations and underlying portfolio metrics could drive positive rating momentum. Positive rating momentum would also be conditioned upon an increase in unsecured debt to above 40% of total debt outstanding and the maintenance of sufficient liquidity, leverage levels commensurate with the risk profile of the portfolio and solid cash earnings coverage of the dividend.

DEBT AND OTHER INSTRUMENT RATINGS: KEY RATING DRIVERS

The alignment of the unsecured debt rating and secured debt rating with that of the Long-Term IDR reflects solid collateral coverage for all classes of debt given OCSL's funding mix and the fact that 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. However, a reduction in unsecured debt as a proportion of total debt could result in the unsecured debt rating being notched down from the IDR.

Best/Worst Case Rating Scenario

International scale credit ratings of Financial Institutions and Covered Bond issuers have a best-case rating upgrade scenario (defined as the 99th percentile of rating transitions, measured in a positive direction) of three notches over a three-year rating horizon; and a worst-case rating downgrade scenario (defined as the 99th percentile of rating transitions, measured in a negative direction) of four notches over three years. The complete span of best- and worst-case scenario credit ratings for all rating categories ranges from 'AAA' to 'D'. Best- and worst-case scenario credit ratings are based on historical performance. For more information about the methodology used to determine sector-specific best- and worst-case scenario credit ratings, visit https://www.fitchratings.com/site/re/10111579

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

Unless otherwise disclosed in this section, the highest level of ESG credit relevance is a score of '3'. This 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. For more information on Fitch's ESG Relevance Scores, visit www.fitchratings.com/esg.

(C) 2023 Electronic News Publishing, source ENP Newswire