Executive Summary / Key Takeaways

• Strategic Reset Through Alignment: Oaktree Specialty Lending has executed a comprehensive strategic reset, cutting management fees to 1%, waiving $20.4 million in incentive fees, and having its manager invest $100 million at NAV—actions that directly align interests with shareholders while improving the company's cost structure and capital base.

• Disciplined Credit Positioning in Uncertain Markets: With 85.9% of the portfolio in senior secured first lien loans and a conservative 6.4% PIK income ratio, OCSL has maintained underwriting discipline amid spread compression and tariff uncertainty, though this has contributed to a 17% decline in investment income to $316.8 million in fiscal 2025.

• Non-Accrual Improvement as Key Catalyst: Non-accruals declined to 2.8% of portfolio fair value in Q4 2025, down 100 basis points year-over-year, with management citing "line of sight" into returning additional loans to accrual status—a critical driver for earnings power given that resolving these positions could redeploy capital into income-generating assets.

• Capital Structure Optimization: The company refinanced its 2025 notes with $300 million of 6.34% 2030 notes, extended its credit facility to 2030 with reduced rates, and maintains $695 million in liquidity—positioning it to deploy capital as market dislocations create opportunities while operating at a conservative 0.97x debt-to-equity ratio.

• Valuation Discount to Peers: Trading at $13.65 per share (0.82x book value) with an 11.7% dividend yield, OCSL trades at a meaningful discount to peers like Ares Capital (ARCC) (1.05x book) and Main Street Capital (MAIN) (1.89x book), reflecting market skepticism that will be resolved through execution on its strategic initiatives.

Setting the Scene: A BDC's Evolution from Passive Lender to Active Credit Platform

Oaktree Specialty Lending Corporation, founded in 2007 and headquartered in Los Angeles, operates as a specialty finance company focused on providing customized credit solutions to middle-market companies with enterprise values between $100 million and $750 million. As a Business Development Company (BDC) regulated under the Investment Company Act of 1940, OCSL functions as a single reportable segment but executes a multi-pronged strategy encompassing direct lending, joint ventures, and opportunistic public market investments. The company's core business model generates current income and capital appreciation by offering flexible financing solutions—including first lien loans, second lien debt, mezzanine financing, and equity co-investments—to companies with limited access to public capital markets.

The BDC landscape has become increasingly competitive, with total industry assets under management reaching $503 billion in Q2 2025. OCSL faces direct competition from scaled players like Ares Capital Corporation (ARCC), Main Street Capital (MAIN), Golub Capital BDC (GBDC), and Blue Owl Capital (OBDC), each vying for middle-market lending opportunities. What distinguishes OCSL is its affiliation with Oaktree Capital Management, one of the world's largest and most respected credit-focused alternative investment managers. This relationship provides proprietary deal flow, deep credit expertise, and access to complex situations that smaller or less specialized BDCs cannot underwrite.

OCSL's current positioning reflects a deliberate evolution. In June 2019, shareholders approved reduced asset coverage requirements, enabling greater leverage flexibility. The company subsequently completed major acquisitions of Oaktree Strategic Income Corporation (OCSI) in March 2021 and Oaktree Strategic Income II (OSI2) in January 2023, more than doubling its asset base. These transactions were followed by strategic debt issuances: $300 million of 3.50% notes in February 2020, $350 million of 2.70% notes in May 2021, and $300 million of 7.10% notes in August 2023. This progression reveals a management team building scale while navigating shifting rate environments—a critical capability for a floating-rate lender.

The most significant recent development occurred in fiscal 2025, when management implemented a comprehensive strategic reset. Effective July 1, 2024, the base management fee was reduced from 1.50% to 1.00% of gross assets. Oaktree waived $20.4 million of Part I incentive fees from October 2024 through September 2025. On February 3, 2025, an Oaktree affiliate invested $100 million in newly issued common stock at $17.63 per share—a 10% premium to the then-market price and NAV. These actions directly address the primary critique of externally managed BDCs: misaligned incentives and excessive fee drag. By cutting fees and investing alongside shareholders, Oaktree has transformed OCSL from a typical fee-collection vehicle into a genuine partnership.

Strategic Differentiation: The Oaktree Advantage and Disciplined Underwriting

OCSL's competitive moat rests on three pillars: Oaktree's sourcing network, disciplined credit documentation, and strategic use of joint ventures. Unlike many BDCs that rely on sponsor relationships alone, Oaktree's platform spans distressed debt, special situations, and structured credit, enabling OCSL to evaluate opportunities across the capital structure and credit cycle. This breadth allows the company to "lean into opportunities with the best risk-adjusted returns" rather than competing solely on price for sponsor-backed deals.

The company's underwriting discipline manifests most clearly in its portfolio composition. As of September 30, 2025, first lien senior secured loans represented 85.9% of the total portfolio at fair value, up from 78% a year prior. First lien debt provides the highest claim on collateral and cash flow, reducing loss severity during defaults. The weighted average yield on debt investments was approximately 9.80%, with 8.90% representing cash payments—a 90 basis point PIK component that remains conservative relative to peers.

Management's approach to PIK income exemplifies this discipline. At 6.4% of total investment income in Q4 2025, OCSL ranks at the low end of its peer set. Armen Panossian, CEO, explicitly stated: "PIK and looser covenants remain popular tools for private debt managers to win mandates and allocations, but we remain extremely disciplined in our credit documentation and acceptance of PIK." This conservatism costs OCSL some deal flow in a competitive market but protects against the PIK trap—where borrowers compound debt obligations until they become unsustainable.

The joint venture strategy provides another layer of differentiation. Through Senior Loan Fund JV I (with Kemper) and Glick JV, OCSL co-invests in broadly syndicated loans, generating additional yield without compromising credit standards. As of September 30, 2025, the JVs held $513 million in investments across 73 borrowers, producing a 12.4% ROE in Q4 2025. The JVs operate at 1.7x leverage, below their 1.5x target, indicating room for optimization. This approach provides a lever to enhance earnings without adding corporate-level leverage or credit risk.

Financial Performance: Evidence of Strategy in Action

Fiscal 2025 financial results demonstrate both the costs and benefits of OCSL's disciplined approach. Total investment income declined 17% to $316.8 million, driven by a $59.6 million reduction in interest income from lower reference rates, a smaller investment portfolio, and non-accrual investments. Adjusted net investment income fell to $151.3 million ($1.76 per share) from $179.3 million ($2.23 per share) in fiscal 2024. This decline reflects the challenging environment for floating-rate lenders as the Fed cut rates, but also OCSL's unwillingness to chase yield by accepting weaker credits or higher PIK.

The quarterly progression reveals a turning point. Q4 2025 adjusted NII was $0.40 per share, up from $0.37 in Q3, driven by normalized prepayment fees, higher dividend income, and reduced interest expense from refinancing activities. This sequential improvement suggests the strategic reset is beginning to bear fruit. Net expenses decreased 21% for the full year to $163.3 million, with $23.2 million coming from lower incentive fees (net of waivers), $12.8 million from reduced interest expense, and $8.9 million from the management fee cut. These savings directly support dividend coverage and NAV growth.

Portfolio quality metrics validate the underwriting strategy. Non-accruals peaked at 4.6% of fair value in Q2 2025 before declining to 2.8% by year-end, a 100 basis point improvement year-over-year. The company resolved several challenged positions: Mosaic generated over 70% of original cost in paydowns, and Telestream Holdings was removed from non-accrual status. Every dollar recovered from non-accruals can be redeployed into income-generating assets, directly boosting NII per share.

The balance sheet provides substantial flexibility. As of September 30, 2025, OCSL had $695 million in liquidity ($80 million cash, $615 million undrawn credit facilities) and a net debt-to-equity ratio of 0.97x—at the low end of its 0.90-1.25x target range. The weighted average cost of borrowings was 6.5%, down from 6.6% in Q3, reflecting the refinancing benefits. This positioning gives OCSL dry powder to deploy as market dislocations create opportunities, while competitors with higher leverage may be forced to retrench.

Outlook and Execution: Levers for Earnings Growth

Management's guidance for fiscal 2026 centers on three explicit levers to offset the impact of lower base rates: prudently increasing balance sheet leverage, optimizing the JVs, and reducing non-accruals while monetizing equity positions. Matt Pendo, CFO, stated the company has "line of sight into, one, putting a portion of our previously non-accruing loans onto accrual status, two, monetizing a portion of our non-accruals, and three, monetizing equity positions." This provides a clear roadmap for NII growth independent of new originations.

The dividend policy change reflects this confidence. The company moved to a $0.40 per share base dividend plus a supplemental dividend equal to 50% of adjusted NII exceeding the base quarterly distribution. This structure establishes a sustainable floor while allowing shareholders to participate in earnings upside, directly aligning with the strategic goal of growing NAV over time.

Pipeline commentary suggests selective opportunity. Armen Panossian noted that while private credit deal flow showed "modest improvement" in Q4, quality was mixed: "We continue to see a steady supply of high-quality opportunities, alongside an increasing number of lower-quality deals coming to market." OCSL's weighted average spread on new deployments was SOFR plus 570 basis points, with first lien loans representing 88% of new originations. This selectivity preserves credit quality while still generating attractive yields, positioning OCSL to benefit when weaker competitors experience losses.

The tariff environment remains a key uncertainty. Panossian observed that "it will be a couple of quarters before tariffs roll through the supply chain and impact portfolio company performance," but emphasized that OCSL was "proactively selling investments within our liquid portfolio that we perceive to have more exposure to negative impacts." This proactive management demonstrates credit discipline extending beyond initial underwriting to active portfolio management throughout the holding period.

Risks and Asymmetries: What Could Break the Thesis

The primary risk to OCSL's thesis is execution failure on non-accrual resolution. While management expresses confidence, the portfolio still contains "chunky positions in the life sciences space" that have remained in workout status for several years. FIO2 represents the most material exposure, and while these positions are "stable to maybe slightly improving," they have not yet reached exit or accrual status. If these positions deteriorate rather than improve, the drag on earnings could persist or worsen, undermining the NII recovery story.

Tariff policy uncertainty creates a macro overhang. Panossian noted that tariff announcements have "thrown a wrench" in private equity activity, causing sponsors to pause new deals and corporate borrowers to delay inventory builds and CapEx spending. OCSL's originations depend on M&A activity and sponsor-backed buyouts. A prolonged slowdown could limit deployment opportunities, forcing the company to either accept lower spreads or shrink its portfolio.

Spread compression remains a structural challenge. Robust CLO issuance and ample liquidity have pulled larger deals into the broadly syndicated market, tightening private credit spreads to SOFR plus 4.25-4.75% for large-cap sponsor loans. While OCSL focuses on the core to upper middle market where spreads are 25-50 basis points higher, the overall trend pressures yields. If competition intensifies further, OCSL may face a choice between accepting lower returns or reducing originations.

The external management structure, despite recent fee reductions, remains a relative disadvantage versus internally managed peers like Main Street Capital (MAIN). While Oaktree's investment at NAV demonstrates alignment, the external structure still involves fees that internal BDCs avoid. In a low-rate environment where every basis point of yield counts, the fee differential can impact competitive positioning and dividend sustainability.

Valuation Context: Discounted Price for Improving Fundamentals

At $13.65 per share, OCSL trades at a significant discount to its September 30, 2025 net asset value of $16.64 per share—a price-to-book ratio of 0.82x. This discount stands in stark contrast to peers: Ares Capital (ARCC) trades at 1.05x book, Main Street Capital (MAIN) at 1.89x book, and Golub Capital (GBDC) at 0.96x book. The valuation gap reflects market skepticism about OCSL's ability to execute its strategic reset and resolve legacy non-accruals.

From a cash flow perspective, OCSL trades at 5.26x price-to-operating cash flow and 5.26x price-to-free cash flow, substantially below the multiples of many BDC peers. The company's 11.72% dividend yield exceeds the yields of ARCC (9.13%), MAIN (7.11%), and GBDC (10.93%), suggesting the market is pricing in higher risk or potential dividend pressure. However, the new dividend policy's base-plus-supplemental structure provides flexibility while the $0.40 quarterly base dividend appears well-covered by Q4 2025 NII of $0.40 per share.

The balance sheet supports the valuation. With $695 million in liquidity and a conservative 0.97x debt-to-equity ratio, OCSL has substantial financial flexibility. The weighted average cost of borrowings at 6.5% is manageable, and the recent refinancing of 2025 notes with 6.34% 2030 notes locks in favorable long-term funding. This capital structure enables OCSL to be a net beneficiary of market stress, deploying capital when distressed sellers emerge.

Relative to peers, OCSL's smaller scale ($2.80 billion portfolio vs. ARCC's $30.81 billion) limits diversification but allows for more specialized underwriting. The Oaktree affiliation provides sourcing advantages that partially offset scale disadvantages, particularly in complex or distressed situations where Oaktree's broader platform can provide unique insights and restructuring expertise.

Conclusion: Execution Will Determine Discount Closure

Oaktree Specialty Lending has completed a strategic reset that addresses the fundamental critiques of externally managed BDCs while positioning the company to capitalize on credit market dislocations. The combination of fee reductions, manager equity investment, debt refinancing, and non-accrual resolution creates a clear path to earnings recovery and NAV growth. The company's disciplined underwriting—evidenced by its 85.9% first lien portfolio and conservative 6.4% PIK ratio—provides downside protection in an uncertain macro environment.

The investment thesis hinges on execution. Management must deliver on its "line of sight" to resolve remaining non-accruals, particularly the chunky life sciences positions that have plagued the portfolio for years. Success will convert non-earning assets into income-generating loans, directly boosting NII per share and justifying the current valuation discount. Failure will prolong earnings drag and validate market skepticism.

The tariff environment and M&A slowdown present near-term headwinds, but OCSL's $695 million liquidity position and conservative leverage enable it to wait for better opportunities while competitors with higher leverage may be forced to de-risk. The company's focus on the core to upper middle market—where spreads remain 25-50 basis points above large-cap loans—provides a sustainable competitive niche.

Trading at 0.82x book value with an 11.7% dividend yield, OCSL offers asymmetric risk/reward. If management executes on its strategic initiatives, the discount to peers should close, providing 20-30% upside to book value while investors collect a well-covered dividend. The Oaktree equity investment at NAV serves as both a catalyst and a signal: the manager believes the stock is undervalued at levels that would represent meaningful gains for current shareholders. For investors, the key variables to monitor are non-accrual resolution progress and deployment velocity of the company's substantial dry powder.