Hidden within Oaktree Specialty Lending Corporation's (OCSL) seemingly routine second-quarter earnings call lies a subtle but potentially seismic shift. While analysts focus on credit quality improvements and the strategic management fee reduction, a closer examination of the transcript reveals a hint of unease about the sustainability of the current BDC boom, particularly fueled by the relentless growth of non-traded BDCs.

The exchange begins innocuously enough, with Wells Fargo's Finian O'Shea inquiring about the trajectory of Oaktree's non-traded BDC, which has consistently attracted $150 million per month. O'Shea probes further, questioning at what level this influx might become a "distraction or burden." The response from Matt Pendo, OCSL's President, is surprisingly nonchalant. He dismisses the concern, stating that the $150 million monthly cadence "works well" for both Oaktree and the non-traded BDC.

However, this casual dismissal belies a deeper truth: the remarkable consistency of this capital flow is becoming an increasingly critical element of Oaktree's strategy. The non-traded BDC, a perpetual fundraising machine, now operates as a reliable source of capital, allowing Oaktree to deploy funds even as traditional BDCs face heightened competition and tighter spreads.

Here's where the hypothesis gets intriguing. Oaktree's recent move to permanently reduce OCSL's base management fee to 1%, a decision widely lauded as shareholder-friendly, may be a preemptive measure. By reducing costs and boosting shareholder returns, Oaktree bolsters the appeal of its publicly traded BDC, potentially attracting investors wary of the illiquidity inherent in non-traded products.

Let's consider the numbers. OCSL's adjusted net investment income is expected to increase by $0.15 per share annually due to the fee reduction. This translates to an estimated 0.8% annual improvement in return on adjusted net investment income. While seemingly modest, this enhanced profitability becomes crucial when viewed alongside the tightening spreads in the private credit market.

Armen Panossian, OCSL's CEO, acknowledges this trend, stating that the market has tightened considerably over the last 18 months. He cites spreads for first-lien loans currently hovering in the "low to mid-500s," a notable decline from the 650 or even 700 spreads witnessed in late 2022 and early 2023. This compression, coupled with heightened competition, makes generating attractive returns increasingly challenging for publicly traded BDCs.

The non-traded BDC, with its steady capital flow, provides a crucial advantage in this environment. Unlike publicly traded BDCs, which are subject to market fluctuations and investor sentiment, the non-traded vehicle offers a stable capital base, shielding Oaktree from the volatility inherent in the public markets.

However, the reliance on this consistent capital inflow carries its own risks. What happens if the non-traded BDC fundraising slows or even stalls? The loss of this reliable capital source could expose OCSL and other publicly traded BDCs to a harsher reality, forcing them to compete more aggressively for a dwindling pool of attractive deals.

Spread Compression in Private Credit Market

The chart below, based on data from OCSL's earnings calls, illustrates the trend of spread compression in the private credit market. This compression puts pressure on publicly traded BDCs to generate attractive returns.

Oaktree's quiet confession about the potential burden of the BDC boom may be an early warning sign. The firm's strategic maneuvering, particularly the management fee reduction, suggests a proactive attempt to insulate its publicly traded BDC from the potential fallout of a non-traded BDC slowdown. While the timing of such a slowdown remains uncertain, Oaktree's actions signal a growing awareness of the inherent risks associated with the current BDC boom.

"Fun Fact: Howard Marks, the co-founder of Oaktree Capital, is famously known for his "memos" to investors, offering insightful and often contrarian perspectives on the market. His writings have become legendary in the investment community for their foresight and depth. Could Oaktree's subtle shift in tone on the BDC boom be a reflection of Marks' inherent caution?"

Investors should heed Oaktree's quiet confession and approach the BDC boom with a healthy dose of skepticism.