Description

“This is not the time period where you say, ‘I can buy anything and not worry about the risk of it.’ The time to do that was 18 months ago.”

-Jeffrey Gundlach, August 2017

Oaktree Capital fair value is 104.6% higher. While I’m awaiting a rerate of the entire private equity space the sizeable distributions as the business is generating fees far below what Oaktree is capable of in good times.

Oaktree capital is a private equity firm lead by the Howard Marks that has made its name in distressed debt investing. Although the units could sell-off in a market downturn, you would still be well positioned as Oaktree capitalizes on its relationships, raising assets and putting out buckets -to paraphrase Buffett - right when it is raining gold.  

What is Oaktree?

Oaktree Capital Management is one of the larger global alternative investment management firms. The firm was formed in 1995. It is a young firm compared to other major private equity peers. Oaktree employs 900 people in Los Angeles (headquarters), New York, Stamford, Houston, London, Paris, Frankfurt, Amsterdam, Dublin, Luxembourg, Dubai, Hong Kong, Tokyo, Singapore, Seoul, Beijing, Shanghai and Sydney. There are 35 portfolio managers with average experience of 23 years and over 813 years of combined industry experience.

The firm prides itself on its investment philosophy, which is built upon

• risk control
• consistency
• market inefficiency
• specialization
• bottom-up analysis
• disavowal of market timing

Oaktree's clients:

• 75 of the 100 largest U.S. pension plans
• 400 corporations around the world
• 38 of the 50 primary state retirement plans in the United States
• 350 endowments and foundations globally
• 15 sovereign wealth funds

Major investment categories:

• distressed debt
• corporate debt
• control investing
• convertible securities
• real estate
• listed equities

AUM by strategy:

Historical investment returns by strategy:

Howard Marks

Co-Chairman Howard Marks is a prominent investor who regularly appears in the media. He is the author of The Most Important Thing and Mastering The Market Cycle which will be released October 2, 2018. He’s perhaps best known for his nuanced memos(here are a few excerpts from the lastest example:

...The bottom line of the above is that some people are excited about the fundamentals, and others are wary of asset prices.  Both positions have merit, but as is often the case, the hard part is figuring out which one to weight more heavily....

....Thus Oaktree will continue to invest on the basis of value and its relationship to price, and to refrain from trying to time markets based on predictions regarding economies, markets or psychology.  The “melt-up” school says securities that already are highly priced may become more so. We’d never bet on whether they will or won’t...

...Investors are still pursuing high returns in a low-return world.  This entails a decline in risk aversion and produces risky behavior, rising asset prices, diminished prospective returns and increased risk.  It’s impossible to say the negatives will win the tug-of-war anytime soon, but that doesn’t mean caution should be discarded . . . especially now...

Insider ownership

At most of the large private equity firms ownership is highly concentrated with founders. At Oaktree they have systematically broadened employee ownership to align interests through the firm. Among its 930 employees there are 294 employee-owners. In an unusual move Oaktree also sold blocks of units to major clients.

Why this opportunity exists

• Asset managers tend to do badly if markets turn. Clients withdraw funds and fee-based-assets shrink organically. Analysts may not want to recommend asset managers at the 2nd highest shiller P/E on record for the S&P 500. Reuters finds zero buy recommendations among 10 analyst estimates (7 hold / 3 outperform).  
  

• The performance fees in PE can be lumpy. Analysts tend to discount lumpy income aggressively.

• The active asset management business is under pressure to lower fees.

• Even the sell-side’s consensus earnings estimates are largely ignored.  

• Tax difficulties because of the partnership structures keep people away.

• The DoubleLine stake is carried at cost.

• Oaktree's share price performance during a downturn has not been observed yet.

• The liquidity of the publicly traded private equity units universe isn’t the best.

• Money flows from active management towards ETFs. Private equity units rarely get included in ETF’s.

Upside

The sell side adds up to a mean estimate of $4.12 end of 19’ mean. Units trade at approximately $41 each. That’s about 10x forward earnings. They are also projecting a 10% long term growth rate in earnings. I can’t quare these widely available projections with generally available alternative opportunities even without considering specific characteristics  of an Oaktree investment.

Source: Reuters

The asset management industry is out of favor. With the emergence of passive as a new dominant force there is significant pressure on fees. In my view the U.S. is leading this charge and Europe is lagging but trending in the same direction. With pressure on fees there’s pressure on earnings which is half of the explanation why asset management is avoided right now.

The other half is the fact that we are nine years into a bull market and with asset management generally having beta to the market it commands a lower multiple when we are near cycle peaks.

Although many industries trade at a lower mean multiple compared to their median shiller P/E multiple asset management’s multiple is much lower compared to a shiller multiple.

Outlook

PwC’s 2020 Outlook Asset Management 2020 looks at the industry through a macro lens. It is an interesting document that echoes some of my observations from bottom-up work which I’ll share. I’m not projecting or counting on things playing out this way but they likely play a role in why asset management is out of favor and some of the signalled trends can be taken in consideration when you are looking at Oaktree’s attractiveness relative to other investment alternatives in the broadest sense.

At a high level PwC foresees asset management as an industry to expand significantly. Even active mutual funds are projected to grow assets under management. The latter projections is one where I believe it when I see it. My estimate is we’re going to see a slowdown of assets towards passive at some point and in the U.S. it doesn’t have that much room to run anymore. PwC could be right about the 2020 figures. From bottom-up work I can confirm there is a trend towards alternatives and in particular private equity type structures. Hedge funds aren’t so hot (the Buffett bet really didn’t fall on deaf ears). Possibly as low interest rates have been a drawback for hedge funds and a boon for private equity.

The industry is better off with a larger alternatives space and a sizeable passive space. A lot of fat is getting cut in the middle. Much of it deservedly so. As allocators are becoming increasingly educated I’d expect the trend to continue:

A few other interesting observations/predictions quoted directly from the PwC report that have relevance and merit:

The expansion and emergence of new SWFs with diverse agendas and investment goals.

The increasing defined contribution (DC) schemes partly, driven by government-incentivised or government-mandated shift to individual retirement plans

Historically, banks have dominated the financial landscape and have traditionally been innovators, as well as first movers. At the same time, insurance companies have always enjoyed enviable asset flows, which have allowed them to create sizable captive AM divisions...

But their influence is expected to have diminished by 2020 and changing demographics and markets will thrust the AM industry to centre stage.

In some parts of the world, alternatives will effectively move into the mainstream to the extent that the term ‘alternative’ may no longer remain in common usage by 2020. Alternatives will become part of the toolset employed in retail products as investors seek strategies with the prospect of alpha and protection against downside risks. However, a blow-up in illiquid assets that affects retail investors could lead to a backlash and a retrenchment of this trend.

Economies of scale will become more important. Some of today’s large global managers will become mega-managers, with a foot in all geographies and channels. Similarly, some of today’s larger alternative managers will become large global managers in their own right with full service alternative product offerings and distribution channels.

Branding will play a major role in the desire to achieve greater scale. Brand will not just be important for asset gathering, but also for their own capital raising. The mega-managers of 2020 and beyond, as well as those firms that aspire to be mega-managers, will need to regularly tap capital markets to fund their expansion. In order to do this, they will need brands that are recognised in all the major markets.

large alternative managers that aspire to global growth will need to fund their expansion by tapping the capital markets, or through strategic relationships with others. Their global brands won’t need to achieve the same global awareness as the mega-managers, but will still need greater recognition in the major markets and through major distribution channels.

Few if any asset managers have created brands that are well-known in both developed markets and SAAAME markets. This is in stark contrast to the banking, consumer and automobile sectors.

Strong branding and investor trust in 2020 will only be achieved by those firms that avoid making mistakes that attract the ire of investors, regulators and policymakers. This emphasises all office functions: front, back and middle, demanding an increased focus on investor reporting and transparency – accuracy, completeness and valuation, by way of third-party assurance – and country-by-country reporting. In addition, firms will make use of state-of-the art technology that helps to identify, segment and retain key clients (see section 6).

Above considerations are indicating asset management is a growth market and established brands have an advantage. Oaktree has developed its reputation aka brand quite actively.

Jay Steven Wintrob - Oaktree Capital Group LLC on the last earnings call:

Michael, thanks for the question. In terms of the outlook for 2018, yes, I do expect that we'll have higher fundraising in 2018 than 2017 and it very well could end up being around those normalized levels we've reported for the last many years. I need to caution you, though. We don't start the year with the focus of the firm being a targeted set amount of fundraising. We try to focus on raising funds where there is commensurate opportunity to invest, and that's going to be market driven. But based on momentum coming out of 2017 and some early things we see in 2018, I do expect to be back at those normalized levels or maybe above in 2018.

In terms of the future, what we know about the future, I see a couple of significant areas of growth in asset classes with large, large markets. I mentioned earlier for us the key areas that we expect to continue growing are real estate, the emerging markets debt and equity platforms, our infrastructure business, the direct lending area, the institutional side or the retail side, for example. And in the open-end area, the global credit fund which is really a compilation of almost all of our most liquid open-end strategies.

Shops that offer actively managed mutual funds look to be the worst positioned while the major private equity shops are actually very well positioned if the future shapes up along those lines.

Valuation

Asset managers are tough companies to value. Important drivers of earnings like assets under management go up and down unpredictably. Especially focused managers with a distinct strategy that pursue alpha and command performance fees have hard to predict cash flows.

My favorite lens to look at asset management firms is through price as a percentage of assets under management. I usually don’t use enterprise value as the business generally doesn’t lend itself very well to leverage.

Valuations have a wide range(illustrated below from another PwC report on asset management valuations Q2 2017):

Important considerations to determine the right level of % of AUM are:

• Height of management fees that can be charged on the assets under management

• Can the assets be withdrawn on short notice or are they locked up?

• Whether performance fees can be charged

• Amount of assets under management

• Firm’s ability to raise additional assets

Currently firms in the alternative space that are demonstrably creating value for clients are undervalued as a class.

It seems likely the value adding alt space can attain something like

• 30-40% EBIT margins

• The industry is likely to outpace GDP growth over a cycle

• Pressure on fees can be best fought off by alts that are creating value for clients. A market pullback could help.

The table below shows the most important publicly traded private equity firms, their market caps and AUM. Firms have different policies to what amount of capital they like to hold on their balance sheet and what they put there. I’ve backed out tangible book value from market cap as a simple adjustment to account for some of these differences. The effect on a firm like KKR, which holds a lot of capital, is profound.

Within its peer group Oaktree Capital is more expensive compared to Carlyle Group and Apollo Group but it is more modestly value than Brookfield or Blackstone. It’s valued about the same as KKR.

The reason Oaktree is currently at the top of my list are its modest valuation combined with four important assets that are often overlooked.

1. Shadow AUM

Oaktree Capital is a distressed debt specialist first and foremost, although it offers other strategies as well. Distressed debt or credit isn’t always available in large quantities and Oaktree refuses to just stuff funds with one or a few sectors like energy, mining or retail.

On the back of its culture, results and solid marketing it has grown assets under management at high speed but if you look closely at the growth rates  you find something interesting:

Growth of assets under management between 2008 and 2009 was one of the most explosive in the firm its recent history (nearly +50%).  

Most if not all asset managers struggle to raise capital in times of distress but apparently not Oaktree Capital. Oaktree can raise capital in 08’ like environments because of its earned reputation to serve clients well and its expertise in the distressed debt sector.

It’s important to stress that the type of AUM Oaktree will raise in the next major bear market is the exact type of AUM that’s most profitable. Those assets will be deployed in Oaktree’s area of specialty and command the highest level of fees they charge. The effect on future earnings should be outsized relatively to assets raised.

Executives have repeatedly stating they are actively refusing money clients want to deploy but Morningstar analyst Stephen Ellis confirms it (perhaps a sign of how unpopular the industry; Morningstar ceased overage):

This focus on clients’ well-being also serves unitholders extremely well, as it builds substantial client goodwill and loyalty, and almost 80% of its AUM involves clients in multiple strategies. Rather than pursue substandard investment opportunities, the firm has suspended marketing for multiple funds in several instances, returned nearly $10 billion in capital to investors before the end of their investment periods, and intentionally turned away billions in capital for other funds to keep the funds sized correctly for the investment opportunity.

Oaktree its assets under management understate its ability to raise capital. While some competitors are continually raising every dollar they can, Oaktree is refraining to do so in order to maximize the capital it can raise at the depth of cycles.

I expect the firm will easily raise $20 - $30 billion of capital if opportunities materialize. There’s potential for them to raise even more if there is a truly significant downturn. Given assets under management would have declined under such scenarios it would be a really major alleviation of pain.

Oaktree would see its management fees start ticking up almost immediately while they are currently below “normalized” levels as Oaktree is actively turning away money.

Meanwhile, Marks is investing a lot of time into client education. He appears regularly in the financial media. He writes lengthy memos that are read widely read (famously by Warren Buffett) and reported on in the financial press. He sits on panels and even does interview sessions. Near the end of the year his new book will be released which is on the topic of market cycles. If the book coincides with a top it could provide a ton of very positive free PR. Oaktree isn’t taking all the money it can, but it is preparing clients to be there when they need them.

In that moment there won’t be time for client education and building relationships so it needs to be done now.

DoubleLine

DoubleLine is an investment management firm lead by Jeffrey Gundlach and focused on fixed income. It’s headquartered in downtown Los Angeles and its AUM equaled $118 billion end of 2017. Oaktree Capital took a 20% stake in DoubleLine Capital at inception which is carried at cost. DoubleLine delivered investment income of $66.1 million and $55.0 million in 2016 and 2015. Unfortunately taxed at the corporate level. In time this stake would probably be better placed into another structure. In case you haven’t heard of DoubleLine and Jeffrey Gundlach, here are some of their awards as listed on the DoubleLine site:

• DoubleLine was named Risk Magazine’s Institutional Investor of the Year” for Shiller Enhanced CAPE in 20161

• Named Risk Magazine’s “Asset Manager of the Year” 2 in 2015

• The DoubleLine team was recognized with Institutional Investors “U.S. Fixed Income—Mortgage Backed Securities” award in 2013, 2014 and 20163

• Awarded “Bond Manager of the Year” by Foundations & Endowments Money Management in 20114

Jeffrey Gundlach’s Accolades

• 2017 Inducted into the FIASI Fixed Income Hall of Fame5

• 2016, 2015 and 2012 Named to Bloomberg Markets’ magazine6 “50 Most Influential”

• 2014 Named one of Forbes7 “Most Powerful People”

• 2013 Named Institutional Investor’s8 “Money Manager of the Year”

• 2011 Named “Fund Leader of the Year” by Fund Action9

• 2011 Named to Fortune Magazine’s Investor’s Guide10 “Mutual Fund All-Stars”

• Lead portfolio manager, was a nominee for Morningstar’s “Fixed Income Manager of the Decade”11in 2009

Average fees across the DoubleLine funds are in the ballpark of 0.5%-0.6% of AUM. That’s on the high side for a fixed income shop. Lately they have been adding strategies that tend to command higher fees.

Morningstar ratings are very important to gather assets. Especially if you are targeting retail. But until recently they didn’t publish any reports on DoubleLine. Now they do but with many negative qualifiers like this one:

In 2014, we assigned this fund a Not Ratable designation after DoubleLine denied repeated requests for access to the firm’s personnel and information on its strategy. With this review, we have revisited the fund’s rating and focused on what we do and don’t know. Manager Jeffrey Gundlach is one of the industry’s most skilled practitioners, with an impressive record that spans more than two decades. However, we continue to lack crucial details regarding the fund’s process and stewardship that the firm’s public filings and communications do not sufficiently address. As a result, this fund receives a Morningstar Analyst Rating of Neutral.

With 80% of DoubleLine’s AUM raised from individual investors perhaps Morningstar’s due diligence team isn’t the only team that’s been getting the boot. There is significant room for the firm to raise assets.

I value DoubleLine at a very generous 3.5% of AUM given its specific characteristics:

Pros

• Fixed income AUM is more stable
• High fees means high margins at additional business
• Prolific leadership (Gundlach has 32.000 Twitter followers)
• Room to raise money from institutions
• Growing assets under management
• AUM / People
• DoubleLine wants to expand horizontally

Cons

• Fixed income AUM commands lower fees
• Few opportunities to charge performance fees
• Gundlach wants to limit AUM ~$150 Billion  
• We’re coming off a bond bull market

If you value this stake at 3.5% of Assets Under Management it is worth $4.13 billion. Oaktree’s stake would be worth $826 million.

Oaktree's off-balance sheet performance fees

Oaktree Capital does not put performance fees that would be earned if funds were liquidated immediately on its balance sheet. There is about $1.3 billion of such net performance fees.

BDC’s

Recently Oaktree completed a transaction in which it became the new investment adviser to two BDC’s Oaktree Specialty Lending Corporation (NASDAQ: OCSL) and Oaktree Strategic Income Corporation (NASDAQ: OCSI).

Oaktree paid $320 million in cash to Fifth Street Management LLC, to get the management. Advising BDC’s is terrific business because Oaktree altered the fee schedule only slightly and now charges:

-OCSL 1.5% on its $1.42 billion of gross assets under management with a hurdle rate of 6% and performance fees of 17.5%.

-At OCSI Oaktree charges 1% on $541 million of gross assets under management with a similar performance fee.

Just in management fees Oaktree should start pulling $26 million per year before performance fees. In addition Oaktree started working to lower borrowing costs cashing in on their reputation? It looks like a great transaction to me assuming Oaktree is an expert determining what kind of book they picked up. These BDC’s could turn into terrific growth platforms for the firm and this relatively recent transaction isn’t properly reflected in Oaktree’s value.

When placing Oaktree somewhere along the valuation spectrum I’m adjusting for the above (except DoubleLine which is easier to add later) in addition to these factors:

Pros

• High management fees

• Attractive performance fees

• Does not carry earned performance fees on balance sheet

• High and widespread insider ownership

• Locked up assets

• $20-$30 Billion of shadow AUM (not reflected anywhere but will be raised in a crisis or recession)

• Solid historical asset growth (even during the emergence of passive)

• Highly specialized funds

• A powerful brand / reputation for putting clients first

• Widely recognized leadership

• Sticky client relationships

• Strong historical returns

• Room and opportunity to diversify horizontally and geographically

• Fees will pick up during and after recessions/drawdowns/crisis

Cons

• Firm does not prioritize asset growth
• Strategies are not the most scalable
• Client first mentality and can forego short term payoffs
• Key man risk

Valuing Oaktree at 10% of future peak AUM for a market cap of $12.5 billion is a fair reflection of where Oaktree Capital should trade over time given underlying economics and characteristics. It's on the high side of peer multiples and I've taken the unusual liberty to count phantom assets under management. We could add in another $800 million for DoubleLine’s value for a total of $13.3 billion. This represents a 104.6% increase from where we are now. This isn't the most conservative valuation I've ever done but if you cut it substantially there is still a lot of upside. While awaiting a rerate of the entire private equity space, the sizeable distributions are enough to keep up with all but strong bull markets.

Risks

Key man risk - There’s definitely some key man risk here. I’ve put some weight on Marks reputation as a great investor, his memos and his books. He’s 69 years old and could chose to retire at some point. In my observation successful value investors enjoy investing so much they only reluctantly retire so that makes me feel somewhat better.

Market crash - If there’s a market pullback it would not be surprising to see Oaktree's unit price fall as well. Especially tied to a recession it would probably affect earnings negatively in the very short term. I fully suspect once the big funds get raised this won’t go unnoticed. Just keep in mind I’m not sure what the price will do. From an ownership standpoint the sooner, the better.

Insider selling - Recently there has been some insider selling. I’m specifically mentioning it because it is not a good sign. It’s rare such selling is followed by a major unexpected positive event.

Note

I wanted to put the quotations which are indented in italic as well but the editor wouldn't let me. 

Catalyst

-High yield crisis

-A general market sell-off or an industry crisis

-Howard Marks new book