How Blue Owl constructs a direct lending portfolio

We prioritize companies in recession-resilient industries such as software, healthcare, food and beverage, and insurance brokerage with no sector comprising more than 15% of the portfolio across our diversified funds. Simplistically, we avoid companies in deeply cyclical end markets such as heavy industrial, housing, oil & gas, retail, and hospitality. Rather than trying to ‘time the cycle’ by selectively investing in these segments of the market, we prioritize investing in sectors that can have durable and stable cash flows. In contrast, public credit market indices are generally more heavily weighted toward cyclical investments. Over time, we believe this sector bias can lead to potentially lower defaults and higher recoveries for our investors.

We aim to construct diversified portfolios with maximum position sizes of 1-2% for high-conviction investments. Our average position size across the platform is only approximately 30 basis points. Of course, our maximum return as a lender is par value plus interest payments, so our upside is capped. With a highly diversified fund, no single outsized position should significantly impact our returns. This can differ from some other investment strategies, such as private equity, where ‘big winners’ can offset large principal losses.

Our experience shows that larger businesses tend to be more resilient during challenging economic periods. They typically benefit from greater diversification, strategic significance in their marketplaces, and resources to weather cost pressures. As a result, large companies can often be less susceptible to severe dislocation from unexpected events and can have longer runway in an economic downcycle. They also generally garner higher valuations and equity cushions than smaller peers. Today, average EBITDA¹ across our direct lending portfolio is over $200 million.

The vast majority of our investments are senior secured, first lien loans that attach at the top of the capital structure. This means there is no debt ahead of our investments, and we have a first-priority claim on the company's assets in a downside event. We also generally have a financial maintenance covenant and comprehensive set of negative covenants that govern each borrower. We believe stable and predictable earnings from first lien loans can offer compelling risk-adjusted returns to our investors. We will selectively look at junior capital such as second lien loans, unsecured debt or preferred equity. However, our bar is extremely high for those instruments.

We are focused on ensuring our borrowers have sufficient cash flow to service their debt and perform their day-to-day operations. We believe this is important not just in today’s elevated interest rate environment, but across the market cycle. For every deal that we do, we develop our own independent assessment of a company’s EBITDA by eliminating one-time acquisitions, events, or initiatives that may contribute to a company’s earnings on paper, but do not generate actual cash for the business. In turn, this analysis helps us determine the appropriate amount of leverage a company can support over time. 

We primarily lend to sponsor-backed businesses. High-quality private equity firms bring an array of financial, operational, and managerial resources to drive positive outcomes at their portfolio companies. They typically have ample dry powder to fuel growth initiatives and acquisitions, and to provide additional liquidity support if needed. At the time of purchase, these sponsors write large cash equity checks beneath our debt, aligning our interests in the success of the company. Notably, the average equity cushion is approximately 60% across our direct lending platform, which means the equity has more 'skin in the game' than lenders as a result.

In summary, we are fundamental investors and make each individual investment using bottoms-up analysis. Additionally, we think about the portfolio as a whole - striving to match our risk exposures to the most attractive parts of the economy and highest-quality companies. Our underwriting expertise and sector-specialized capabilities allow us to make prudent decisions and identify certain alpha-generating opportunities. This framework has helped us achieve strong credit performance to-date - with anon-accrual rate of less than 1% and realized loss rate of only 6 basis points across the direct lending platform – and we believe this also positions us to deliver compelling risk-adjusted returns over the long-term.

Logan Nicholson is a Managing Director at Blue Owl and member of the Direct Lending Investment Team. Logan is also a Portfolio Manager for certain funds in Blue Owl’s Diversified Lending strategy, including Blue Owl Capital Corporation (NYSE: OBDC) and Blue Owl Credit Income Corporation (OCIC). In his role, he is responsible for the day-to-day management and strategic oversight of the credit selection and portfolio management process across the funds he covers.