Oxford Lane Capital: The Cash Keeps Flowing And The Market Keeps Growing (NASDAQ:OXLC)

Thomas BarwickOxford Lane Capital Corporation (NASDAQ:OXLC) is a unique closed end fund operating in a niche and underserved segment of income. OXLC is similar to Eagle Point Credit Company (ECC) as one of the few publicly traded participants in collateralized loan obligations or CLOs. Following up on our prior coverage of OXLC, we are revisiting the fund to see what has changed and assess the outlook of secured lending. Over the years, the credit markets have unlocked for investors. Generally speaking, investment grade bonds have been the focus of most fixed income investors looking beyond treasuries, municipal bonds, or certificate of deposits. The bravest would venture off into high yield debt from below investment grade issuers. However, private and securitized credit were untouched by individuals aside from family offices or other ultra-high net worth individuals. Over the past decade, a variety of publicly traded companies participating in securitized credit have appeared, including OXLC and ECC. Additionally, funds focusing on the higher rated CLO tranches have appeared including Janus Henderson AAA CLO ETF (JAAA) and Janus Henderson B-BBB CLO ETF (JBBB). As the market grows aggressively, funds like OXLC have taken off in popularity. Offering some of the highest available yields, investors of all shapes and sizes have been interested in what these funds can offer. Today, we dive back into OXLC and the outlook for credit. The Fund Data by YChartsOXLC is a company hiding as a closed end fund. While the company is structured as a closed end fund, OXLC does more than hold securities. The company also acts as an originator, aggregating loans to combine into securitizations. OXLC describes their business in their annual report. Oxford Lane Capital Corp. is a publicly-traded, registered closed-end management investment company. It currently seeks to achieve its investment objective of maximizing risk-adjusted total return by investing in debt and equity tranches of CLO vehicles. The Fund’s investment strategy also includes warehouse facilities, which are financing structures intended to aggregate loans that may be used to form the basis of a CLO vehicle. As OXLC aggregates loans, they keep positions in the equity and junior debt tranches. For those unfamiliar, we will discuss the structures of tranches in the next section. As of March 31, nearly 95% of the portfolio was allocated to CLO equity with the remaining portion invested in the junior debt tranches. The highest rated CLO tranches are generally sold to large institutional investors such as pension funds or sovereign wealth funds. OXLC Annual Report OXLC focuses on the equity tranche for two reasons. First, larger investors seeking CLO exposure may be uncomfortable with the risk profile of the equity tranche. Most large CLO investors are looking for stable, floating rate exposure. The senior tranches offer AAA or AA rated cash flow with a healthy spread over SOFR. The equity tranche is inherently more volatile and may not fit that profile, leaving a demand gap for low rated tranches. Second, as the originator, it makes sense for OXLC to retain their underwritten cash flow buffer. With their underwriting expertise, they have a vested interest in keeping the CLO healthy and performing. The company’s annual report offers transparency into the portfolio including a complete list of CLOs. The company provides data points on acquisition date, cost basis, and fair value. Fees and expenses are another important consideration for OXLC investors. As a closed end fund, OXLC charges a management fee on assets under management. OXLC clarifies that the management fee calculated above is a percentage of net assets. The defined management fee in the Investment Advisory Agreement is based on gross assets which includes leverage. This means as leverage increases, the fund’s effective expense ratio increases. This is somewhat problematic structure from a risk alignment perspective for the fund’s management team, but not uncommon. OXLC Annual Report Like most private funds, OXLC also charges an incentive fee of 20% over what they define as “Pre-Incentive Fee Net Investment Income”. The annual report describes the fee structure as follows: The incentive fee, which is payable quarterly in arrears, equals 20.0% of the excess, if any, of our “Pre-Incentive Fee Net Investment Income” that exceeds a 1.75% quarterly (7.0% annualized) hurdle rate, which we refer to as the “Hurdle”, subject to a “catch-up” provision measured at the end of each calendar quarter. The incentive fee is computed and paid on income that may include interest that is accrued but not yet received in cash. The operation of the incentive fee for each quarter is as follows: no incentive fee is payable to Oxford Lane Management in any calendar quarter in which our Pre-Incentive Fee Net Investment Income does not exceed the Hurdle of 1.75%; 100% of our Pre-Incentive Fee Net Investment Income with respect to that portion of such Pre-Incentive Fee Net Investment Income, if any, that exceeds the Hurdle but is less than 2.1875% in any calendar quarter (8.75% annualized) is payable to our investment adviser. We refer to this portion of our Pre-Incentive Fee Net Investment Income (which exceeds the Hurdle but is less than 2.1875%) as the “catch-up.” The “catch-up” is meant to provide our investment adviser with 20.0% of our Pre-Incentive Fee Net Investment Income, as if a Hurdle did not apply when our Pre-Incentive Fee Net Investment Income exceeds 2.1875% in any calendar quarter; and 20.0% of the amount of our Pre-Incentive Fee Net Investment Income, if any, that exceeds 2.1875% in any calendar quarter (8.75% annualized) is payable to Oxford Lane Management (once the Hurdle is reached and the catch-up is achieved, 20.0% of all Pre-Incentive Fee Investment Income thereafter is allocated to Oxford Lane Management) Bottom line expenses for OXLC amount to expenses closer to an entire company or private credit fund. OXLC recently issued additional debt as the company continues to grow. On June 27th, OXLC announced the issuance of $100 million in fixed rate debt due in 2030. Per the press release, the interest rate is 8.75% and the loan will be used to fund additional acquisitions and corporate activities. Oxford Lane Capital Corp…today announced that it has priced an underwritten public offering of $100,000,000 in aggregate principal amount of 8.75% unsecured notes due 2030. The notes will mature on June 30, 2030, and may be redeemed in whole or in part at any time or from time to time at the Company’s option on or after June 30, 2028. The notes will bear interest at a rate of 8.75% per year payable quarterly on March 31, June 30, September 30, and December 31 of each year, commencing September 30, 2024. The Company expects to use the net proceeds from this offering to acquire investments in accordance with its investment objective and strategies and for general working capital purposes. OXLC continues to be a fast paced growth engine with an expanding capital stack. However, OXLC’s aggressive growth comes at the peak of an interest rate cycle. With the Federal Reserve pointing to rate cuts in the next six months, OXLC is issuing fixed rate debt at the highest possible rate. Performance & Dividend OXLC’s long term performance can accurately be described as a “Tale of Two Cities.” Over the long term, there have been several important divergences which may play an important role for investors deciding where to put OXLC in their portfolio. First and foremost, the divergence of price and total return. Data by YChartsOXLC’s share price has declined consistently since the fund was launched nearly 15 years ago. At initial public offering, common shares of OXLC traded at $20 per share. Today, common shares of OXLC trade in the $5 range. However, OXLC is a closed end fund and distributes a monthly dividend which has more than compensated for the price declines. Currently yielding almost 20% with a recent dividend increase, OXLC is one of the highest yielding exchange traded investments. As the dividend now grows, OXLC has disproven many naysayers. Data by YChartsOXLC has also outperformed traditional fixed income categories including bond ETFs (BND) and traditional money market funds (VMFXX) at the expense of added volatility. Bonds and money markets offer modest returns with the added benefit of stability. OXLC has a very different value proposition. CLO funds and private credit live underneath the monicker of “credit investments with equity-like returns.” The proof was in the pudding. Data by YChartsThose willing to live with the added volatility have a considerable opportunity to profit from a high performing, high yielding asset class. Let’s discuss the assets in greater detail to gain an understanding of where OXLC lives in the ecosystem. What Is A Collateralized Loan Obligation? Collateralized loan obligations or CLOs are a rapidly-growing, trillion dollar asset class within the broader credit industry. CLOs are actively managed portfolios of non-investment grade, senior-secured loans typically made to middle market companies. These companies are larger than small businesses but too small to access traditional capital markets via investment banks. Guggenheim InvestmentsCLOs acquire portfolios of hundreds of individual loans and bundle them together into a single cash flow. This single cash flow is separated into a stack of cash flows, known as “tranches” prioritized by claim to the interest income. The debt tranches issued by CLOs are organized by their seniority on the cash flows of the underlying loan pool. Higher rated tranches have a higher priority claim to cash flows from the portfolio. Each tranche has a descending priority on the interest income received from the loans. Cash flow begins with the highest rated debt tranches of the CLO and flow down each lower rated tranche thereafter, beginning with AA, then moving to A and so on. This descending cash flow is known as a “Waterfall.” The Waterfall has certain limitations and several performance tests designed to prevent non-performance and ensure liquidity. Guggenheim Investments Historically, this has translated to extraordinarily low default rates event amongst the most junior debt tranches. The equity tranche, which is retained by OXLC, is designed to absorb the losses to keep the debt tranches paid. Guggenheim Investments The assembled portfolio of senior secured loans acts as the foundation of a CLO. The interest income is the cash flow distributed to each tranche. Loans are originated by a group of institutional lenders known as a “syndicate.” The majority of loans in any given CLO are first-lien senior secured loans. These loans have the priority claim on the borrower’s assets in a bankruptcy scenario. These loans are a less risky way to invest in the middle market with high interest rates and first claim to assets. Senior secured loans typically carry floating interest rate tied to the Secured Overnight Financing Rate, known more commonly as SOFR. Data by YChartsSenior secured loans generally carry a number of covenants designed to protect the lender. These can include financial requirements or other corporate governance items which can help prevent issues for the lender. The top priority of these loans has historically led to high recovery rates during bankruptcy, due to the asset-backed nature of the loans. However, over time, recovery rates have broadly declined as a larger portion of the middle market becomes comprised of asset-light industries like Software as a Service or SaaS. Guggenheim Investments The most senior debt tranches carry the lowest coupon rate but are paired with the lowest risk factors. Like the underlying loans, CLO tranches are typically floating rate. AAA-rated tranches typically have a modest spread over current SOFR rates. Junior tranches pay higher yields but are exposed to losses earlier. The riskiest piece of the CLO capital stack is the equity position. The equity tranche has no coupon. Instead, the equity tranche collects excess cash flows that were built into buffer losses for the debt tranches. This means the equity tranches usually shrink over time in both cash flow and fair value. Senior and junior debt tranches typically account for 90% of the capital stack and equity tranches account for around 10%. CLOs and similar securitized investments must undergo coverage tests to ensure liquidity and performance of underlying loans. These tests were revamped following the Great Financial Crisis which was issues in the Collateralized Debt Obligation market. This led to the emergence of CLO 2.0 underwriting which has reduced default rates considerably. CLOs also come with a degree of other limitations including concentration limits, requirements for diversification, and credit limitations for underlying borrowers. These pieces are designed to keep CLOs healthy and prevent catastrophic meltdowns. Growth of Secured Lending & Private Credit Over the past ten years, private credit has grown at an unprecedented rate. Private credit are non-public debt investments made by non-bank lenders. These can include alternatives and specialty finance companies like private credit funds or business development companies, known more commonly as BDCs. Private credit is the foundation of CLOs serving as the basis for the underlying loans of each portfolio. These loans were typically made to smaller businesses, but the expansion of private credit has widened the customer set. Today, a considerably larger number of borrowers opt for private credit alternatives. Federal Reserve Private credit is typically known as “direct lending” and involves a far more hands-on approach. The negotiation of terms for each borrower is designed to meet the needs of the company. This is different from the traditional investment banking framework which forces borrowers to comply to a much more stringent set of lending standards. Direct lending typically results in more complex loans, but far more flexibility for the borrower. These loans typically have no secondary market and limited liquidity making them unsuitable for most investors, but perfect for a securitization vehicle like a CLO. Accordingly, CLOs account for an increasing portion of the secured lending market. Guggenheim Investments Private credit and direct lending continue to grow as a new frontier for nonbank lending. Given the limited requirements to partner with a private credit fund, borrowers are increasingly turning to these lenders to fulfill their capital requirements. For borrowers, this can be a variety of needs including generally corporate purposes, recapitalization, or refinancing. Risks The extraordinary growth of private credit over the past ten years presents a unique set of risk factors for OXLC. As the industry grows, there are an increasing number of participants in the industry and an increasing pile of dry powder. The industry’s rapid growth means new demand could compromise traditional underwriting standards which protect lenders. Additionally, the competency of new originators who are trying to fill the demand gap could prove problematic over the long term. For example, interest coverage ratios have broadly declined over the past several years, according to the Federal Reserve. Federal Reserve OXLC is an aggregator of these loans, meaning they must choose from the available pool of loans from the broader market of lenders. If the market of available loans broadly declines, this presents a critical risk factor for an aggregator like OXLC. Additionally, these riskier loans will highlight the importance of a strong equity tranche in the coming years, which may prove necessary during a downturn. Conclusion OXLC is a unique company with their only real competitor being ECC. These two CLO originators offer investors access to the businesses behind CLOs and the equity tranche of the investments that they build. This means there are unique risk factors for investment in shares of OXLC outside of CLOs in general. This begs the question of where OXLC and ECC could fit into a portfolio. CLOs should be a minority of an income portfolio due to their complexity, risk profile, and volatility. However, their track records are compelling, and their outsized yields present an opportunity to materially increase portfolio yield with a small allocation. Data by YChartsAn investment in OXLC is well paired with JAAA and JBBB to build exposure to the entire CLO capital stack. Splitting exposure to these three investments based on an individual’s risk tolerance balance yield, volatility, and downside risk with a unique and underserved asset class. Data by YCharts We rate OXLC a “Hold” as the continued growth of the direct lending market supports the underlying business but presents unique risk factors. OXLC is worth owning due to the generous cash flow distributed by common shares monthly. However, shares are best acquired during off-risk periods where volatility has increased and unrated loans come under pressure. Until that point, shareholders will continue to collect on one of the highest available yields.

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