OFS Credit Company Compared To Two CLO CEF Peers: OXLC And ECC (NASDAQ:OCCI)

OFS Credit score Firm, Inc. (NASDAQ:OCCI) is a non-diversified closed-end fund or CEF which invests primarily in collateralized mortgage obligations (CLO). It’s a micro-cap peer to each Eagle Level Credit score Firm Inc. (ECC) and Oxford Lane Capital (OXLC) which get a good bit of consideration on Searching for Alpha due partly to their excessive dividend yield.

Specifically one of the adopted contributors right here on Searching for Alpha with practically 100,000 followers, Rida Morwa has been bullish on each OXLC and ECC prior to now 12 months. In December 2021 Rida launched Oxford Lane Capital as their first “Pick of the Year for 2022!” Since then OXLC generated whole returns increased than the S&P 500, however nonetheless misplaced round 9% in worth.

Simply final week Rida included ECC as considered one of two shares highlighted in an article entitled “Bet Your Retirement Income on the USA” [The other stock highlighted incidentally is one I wrote up in September 2022 which I think still has value: BrightSpire Capital (BRSP)]. The thesis appears to be that regardless of a doable recession in 2023, ECC is well-positioned given their guide doesn’t have a variety of maturities developing till 2025. Rida states,

“It is a profit as a result of defaults are usually most frequent when loans mature. With the economic system more likely to weaken in 2023, ECC has little or no publicity to corporations that can be compelled to refinance when there are twin headwinds of high-interest charges and a weakening economic system. If there’s a recession in 2023, it is best to not maintain a variety of loans which are maturing mid-recession.

It’s this type of proactiveness from ECC’s administration that offers us the arrogance to proceed holding and gathering the huge +15% yield.”

As is usually with these CLO funds the excessive dividend yield is emphasised. What’s neglected is the exorbitant administration charges these CEFs are charging and historical past of worth destruction. As I’ve written about OXLC in a previous article, one should be cautious that administration isn’t consuming your capital.

OFS Credit score Firm launched their annual report on January twelfth, 2023 and I assumed this could be a great time to check this fund to friends OXLC and ECC. With this text traders can get a bit extra of an outline of the CLO CEF panorama to higher perceive the dangers, and potential rewards.

What Are CLOs?

Earlier than we begin our evaluation it could assist to overview what collateralized mortgage obligations are. Guggenheim Investments describes them as:

“CLOs are a $910 billion asset class inside the broader $12 trillion structured credit score fixed-income market, which additionally contains asset-backed securities (ABS). CLOs derive principal and curiosity from an actively managed, diversified pool of non-investment grade, senior-secured company loans.

CLOs use funds obtained from the issuance of debt and fairness to traders to amass a various portfolio of sometimes greater than 200 loans. The debt issued by CLOs consists of quite a lot of tranches, every with a threat/return profile primarily based on its seniority and declare precedence on the money flows produced by the underlying mortgage pool.”

Increased threat is implied by the non-investment grade ranking, but there’s a tactic employed to theoretically scale back threat via broad diversification of a whole lot of loans. Moreover, the loans are senior-secured and sometimes occupy a first-lien place in an organization’s capital construction. What this implies is that every CLO is an funding car composed of a whole lot of different loans to firms round the US.

CLOs themselves are damaged down right into a capital construction the place debt tranches with rankings from AAA to BB are bought to lift the cash to buy the portfolio of loans. Primarily which means that CLOs elevate cash, purchase loans, repackage them, after which promote them again to traders. They even have their very own managers, and preserve a variety of different individuals in enterprise as in accordance with Reuters they are the largest buyers of leveraged loans.

Debt funds from the underlying pool of loans are consolidated and distributed to traders of those numerous tranches. These with the very best rated AAA tranches are paid first whereas these with fairness tranches on the backside of the capital stack are paid last.

In line with a working paper from the Philadelphia Fed investigating CLO efficiency, the typical IRR for CLO fairness tranches was 9.88%. They acknowledged additional that:

“Our central discovering is that CLO fairness tranches present statistically and economically important irregular returns, or “alpha,” in opposition to quite a lot of public benchmarks. Utilizing the generalized public market equal (GPME) framework of Korteweg and Nagel (2016), we discover that the typical accomplished CLO fairness funding provides a internet current worth (NPV) of 66 cents per greenback invested, internet of charges. This estimate equates to roughly $33 million, or 6.6% of whole property, for the standard deal.”

As we’ll see in a second these fairness tranches are predominantly what OCCI, OXLC, and ECC are invested in. The Fed’s analysis offers us a benchmark determine grounded in knowledge of round ~10% returns on these tranches. Our analysis will look into how these fund’s returns stack as much as this benchmark.

It is a transient abstract introduction to CLOs, and they don’t seem to be a easy subject in my judgment. If you end up studying this and nonetheless questioning how this stuff work, then OFS Credit score Firm just isn’t a smart funding. If you don’t perceive one thing, don’t put your cash on it. That goes for OXLC and ECC as effectively.

Historical past and Technique of OFS Credit score Firm

The corporate was established in 1994 as an offshoot of OFS Capital (OFS) and a part of a gaggle of companies managed by Richard Ressler that personal, function, and handle greater than $35 billion of actual property and company credit score. Since 1994, OFS Capital has invested over $20 billion in additional than 10,000 transactions. At current OCCI manages $3.8 billion in property.

We will see that their acknowledged focus has been on CLO fairness and debt. These parts make up 91.4% of their portfolio – with a heavy weighting in the direction of CLO debt.

The corporate originally priced its initial public offering of two.5 million shares of frequent inventory at $20.00 per share in October 2018. Their inventory worth opened at $19.00 which it solely noticed as soon as extra earlier than establishing a long run decline to the place it trades right now at $9.54. Which means the inventory has shed round half its worth in 5 years.

Not solely has the inventory declined in worth, shares excellent have ballooned from ~2.5 million to 9.4 million. House owners from 2018 have seen their possession curiosity considerably diluted by this 276% development of shares whereas worth has evaporated.

Internet asset worth (NAV) per share in their first few months was $20.11. As of January twelfth, 2023 it was reported at $9.98 translating to round half of its worth misplaced in simply 5 years. The annualized rate-of-return could be a lack of 10% annually – fully reverse of the Fed’s benchmark IRR of +10%.

Regardless of CLO fairness tranche efficiency being so good that the Fed is investigating it, OFS Credit score Firm has managed to invert expectations into the fact of capital destruction. This sample of NAV erosion was obvious with Oxford Lane Capital as effectively which noticed a -71.7% decline of NAV in twelve years (-6% yearly).

OFS Credit score Firm Expense Ratio

There would should be a really compelling purpose for me to need to make investments alongside managers who’ve destroyed half of unique NAV in simply 5 years. What’s astonishing is that traders are literally being charged huge charges for this harmful efficiency.

Whole expense ratio on NAV of $9.98 is 17%. Once you take a look at your inventory charts and see OCCI buying and selling you’re being provided the chance to have 17% of your capital expensed by managers who’ve eroded NAV by -10% annually.

Sounds attractive, proper?

OXLC and ECC final reported expense ratios of 10.84% and 12.79% respectively. This places OCCI on the very excessive finish of friends. And it alone is sufficient of a purpose for me to place this within the promote pile. A longtime historical past of NAV destruction and customary share dilution remind traders of the outcomes they’re more likely to see.

OFS Credit score Firm In comparison with OXLC and ECC

Let’s check out some peer metrics to get a greater sense of OCCI as an funding. Listed here are some baseline statistics relating to the three funds.

Ticker	Inventory Worth	Market Capitalization (thousands and thousands)	P/B	Annual Dividend Yield	Expense Ratio	% of Portfolio in CLO Fairness
OCCI	$9.54	$89.50	0.96	23.06%	17.05%	89.70%
OXLC	$5.69	$902.50	1.15	15.82%	10.84%	97.00%
ECC	$10.51	$459.10	1.03	15.98%	12.79%	76.10%

Click on to enlarge

We will be aware right here the scale distinction between OCCI and its friends. The inventory may be very practically buying and selling at guide worth at 0.96x which can also be its three-year common P/B. The small differential between OCCI and the opposite two funds in valuation is extra pronounced if we take a look at the dividend yield.

Recall earlier that the typical returns for CLO fairness positions in accordance with the Fed is round 10%. When in comparison with the dividend yields of those corporations it appears reasonably troublesome to think about the mathematics understanding over the long run. Common annualized returns of 10% merely wouldn’t cowl the 15-23% dividends implied right here.

And what extra could be anticipated however common outcomes from the varieties of portfolios which are being constructed. Take OXLC as an example with their portfolio of 221 investments inclusive of CLO debt and CLO fairness positions. The whole variety of underlying loans throughout these 221 investments totaled 2,003 as of September 2022. These loans are unfold throughout 1,717 obligors which represents the variety of corporations that OXLC must preserve tabs on.

Eagle Credit score Firm equally manages a portfolio with 1,868 distinctive underlying mortgage obligors as of December 2022.

OFS Credit score Firm doesn’t even escape this knowledge for traders. What we do know is that in October 2022 their prime 10 underlying obligors made up 5% of their whole. If we assume a median allocation of 0.3% for the remainder of the portfolio that will indicate round 320 totally different obligors.

As somebody that tries to maintain up with an energetic portfolio involving 9 totally different corporations, the thought of managing a whole lot of positions is mind-boggling to me. I align extra with the concept that diversification is a safety in opposition to ignorance. As Warren Buffett stated,

“If you know the way to investigate companies and worth companies, it is loopy to personal 50 shares or 40 shares or 30 shares, most likely, as a result of there aren’t that many fantastic companies which are comprehensible to a single human being, in all probability.

And to have some super-wonderful enterprise after which put cash in quantity 30 or 35 in your listing of attractiveness and forego placing extra money into primary, simply strikes Charlie and me as insanity.

And it is typical apply, and it could — you already know, in case you all it’s a must to obtain is common, it could protect your job. But it surely’s a confession, in our view, that you do not actually perceive the companies that you just personal.”

A Be aware of Potential Pricing Inefficiency

I not too long ago wrote an unique article for the Microcap Review a few industrial mortgage REIT. The corporate is a steadiness sheet lender which means they straight originate loans sometimes secured by actual property. Notably this firm and the eight friends I in contrast it to function as CLO managers and straight originate the underlying loans which typically comprise them.

I carry all of this up as a result of throughout the group the typical P/B ranking was 0.66x. Administration from these corporations have mentioned deterioration in markets amidst a looming recession and the should be conservative transferring ahead.

Peer	P/B	Market Capitalization (Hundreds of thousands)
Starwood Property Belief (STWD)	0.96	$6,200
Ladder Capital Corp (LADR)	0.92	$1,400
Blackstone Mortgage Belief (BXMT)	0.85	$4,000
Ares Business Actual Property Corp (ACRE)	0.80	$630
BrightSpire Capital	0.66	$940
KKR Actual Property Finance Belief (KREF)	0.66	$1,100
TPG RE Finance Belief (TRTX)	0.56	$615
Granite Level Mortgage Belief (GPMT)	0.32	$324
ACRES Business Realty Corp. (ACR)	0.19	$85
Common	0.66	$1,699

Click on to enlarge

*Information pulled from TD Ameritrade on 01.13.2022.

It’s a bit stunning to see these CLO funds buying and selling at a P/B valuation increased than REITs. If industrial mREITs predict to see guide worth cuts amidst this present atmosphere then it appears seemingly that funds which purchase the loans these mREITs originate would seemingly stand to see some cuts as effectively.

Learn the Advantageous Print on OCCI’s Dividend

As a part of the corporate’s dividend coverage the annual distribution of $2.20 is proscribed to a 20% payout in money. The opposite 80% of this dividend is paid out in further shares of frequent inventory. What this implies virtually is that for dividend traders who could also be searching for secure earnings, they need to bear in mind that in actuality this 23% annual dividend would solely equate to $0.44 money.

We will observe a perpetrator to the ballooning share rely on this dividend coverage. It creates an phantasm of a better dividend when in actuality 80% of the dividend actually simply displays a change in possession curiosity.

Is OCCI A Good Funding?

OFS Credit score firm has established a 5 12 months pattern of worth destruction, possession dilution, and expense extraction. It’s at present buying and selling close to guide worth in expectation that this 5 12 months pattern is probably a fluke. As an alternative it appears more likely to me that worth destruction will return to this inventory.

As a CLO fund, administration invests throughout an enormous vary of corporations hoping to mete out common returns in any case. As an alternative, they’ve managed to lose 10% yearly whereas sustaining extremely excessive expense ratios. The idea is that administration of so many alternative positions should require particular data or experience justifying the excessive bills.

However what justifies the poor efficiency?

These funds appear designed to confuse the typical traders with greed. The obvious excessive dividend yields are bait placing traders on the hook for these corporations’ bills. In flip the businesses actively handle a portfolio of loans to upwards of 1000’s of various corporations, and keep a paycheck as well.

The corporate’s that feed these CLOs like industrial mREITs are already pricing in guide worth declines attributable to a recession. If we have been to imagine an identical 34% common low cost to guide worth OCCI would commerce at $6.59.

However again to the query, is OCCI a great funding? In my judgment, completely not. I believe traders are a lot better off trying away from this whole class of funds and as an alternative trying to corporations like industrial mREITs which originate these kind of loans straight.

Editor’s Be aware: This text covers a number of microcap shares. Please concentrate on the dangers related to these shares.