Description

OVERVIEW

·         OZM was written up on VIC as a long investment in January.

·         We rated this write-up as a “1” in the Peformance Rating, which is described by VIC as “Would Take Opposite Position”

·         Given that we have had several of our write-up receive “1” ratings, and knowing how irksome it can be to see these ratings without any comment, we figured we would share our alternate view on OZM.

·         Below we outline our summary thesis, and then we cover several points in the January thesis, and discuss our divergent viewpoints

SUMMARY THESIS

·         OZM has experienced a meaningful reduction in its Assets under Management (AuM)

·         Revenue is declining at a faster rate than AuM, as price cuts and product mix hurt fee capture rate

·         OZM has not been able to cut costs at the same rate of revenue decline

·         At current AuM levels, we believe that OZM generates a negligible level of management fee-related earnings

·         Incentive-fee earnings are likely to be structurally lower going forward

·         OZMs capital structure is an outlier versus its peers, placing it in a disadvantaged position

·         In sum, we believe that it is difficult to justify OZM’s current share price, we believe the stock is overvalued by over 30% in a reasonable base case, and the risk-reward is not skewed in the favor of shareholders

REBUTTAL OF JANUARY WRITE-UP

·         January Write-Up: OZM has a “fairly simple economic model”

·         Our View: The ongoing mix shift in OZM’s AuM base has significantly altered the future earnings power of the business

o    OZM is enduring a very challenging mix to its asset base. As of 12/31, high fee-earning Multi-Strategy AuM was ~21bn, down from a peak of $34bn in 2014.

§  Multi-Strategy Funds earn an average ~1.35% management fee (per 9/30 10-Q, PF for announced fee reduction)

o    This decline has been offset by the growth in other AuM (Credit, Real Estate, etc), which has grown from ~$13bn to $17bn

§  Opportunistic Credit Funds earn an average 88bps management fee, and CLOs earn an average 39bps (10-Q)

o    In addition to the lower management fees, we believe there is lower performance-fee potential in the growing assets

§  We believe that Credit and Real Estate funds contain preferred return hurdles, and CLOs, which currently represent over 20% of total AuM, are not expected to earn meaningful incentive income

o    It is important to note that as of 2/1, OZM reported AuM of $33.6bn, down from $37.8bn at 12/31… this is a decline of $4.2bn… while we won’t know the breakout of this AuM decline until Q1 earnings, we believe that it is likely possible that Multi-Strategy AuM represented over 100% of that decline, and that current AuM on Multi-Strategy could be in the ~$16bn range

o    We believe this negative mix will continue to impact both the blended management fee rate, and the upside in performance fees

·         January Write-Up: “OZM is being valued at ~5x ‘18E P/E” and is cheap to peers, and historical average valuation

·         Our View: OZM currently generates very little fee-related income and as such comparisons to peers and historical valuation are irrelevant

o    At current AuM and cost structure, we believe OZM generates very little, if any fee-related income.

o    This is important, because the market perceives fee-related income as higher quality (recurring income versus performance fee income which is lumpy), and as a result ascribes it a higher multiple. We believe the consensus among sellside analysts is that fee income should be valued at 10x-16x, while performance fees should be valued at 4-6x

o    Comping OZM to other alternative managers we believe is irrelevant. Other managers have a much higher percentage of AuM from fee-related income, and therefore deserve a higher multiple.

o    The same issue arises in comping OZM against itself, as in the past, with higher AUM, OZM earned more of its income from management fee revenues, and had a higher concentration of AuM in higher performance fee generating Multi-Strategy assets

o    We believe that using a blended multiple of management fee-income and performance-fee income for OZM yields a blended multiple far below peers and historical average multiples, which we discuss further in our valuation section

·         January Write-Up: “FCPA Investigation: This is now behind us”

·         Our View: The FCPA investigation left a significant mark on OZMs balance sheet, and has left it with a disadvantaged capital structure

o    OZM also differs from many of the other alternative asset managers in its capital structure. OZM has a significant net debt balance, while many peers have sizeable net cash positions

o    Clearly the financial leverage adds an element of risk to the equity that is not present in many other alternative managers

o    Additionally, $400mm of OZM’s debt is a preferred (issued by the GPs to fund the recent legal settlement) which does not accrue interest until 2020. At a rate of 7%, we calculate that this would be dilutive to EPS by 4c per share. At a rate of 12%, virtually all of OZM’s fee-related income gets wiped out.

·         January Write-Up: “30-40% of overall incentive income generated” is paid in annual bonuses

·         Our View: Recent data points paint a different picture on shareholder participation in incentive income

o    while the 30-40% payout number from the January write-up is technically true stretching back over a long time period, we believe there are other more relevant data points that paint a different picture

o    In 2015, OZM generated over $200mm of incentive income, and paid out ~95% of that in cash bonuses. Similarly, in 2016, OZM generated over $230mm of incentive income, and paid out 95%

o    In years when the Master Fund had a down year, 2008 and 2011, OZM paid out 6x and 2x the incentive income in bonuses. This implies a significant minimum level of bonus regardless of performance

o    This was confirmed on the conference call this morning, where management indicated that it will change its accounting to accrue for cash bonuses quarterly at 18-20mm per quarter, which appears to be incremental to any bonus earned from incentive performance. This implies a base bonus of 72-80mm, regardless of performance.

·         Our View: The recently announced share based compensation plans appear highly dilutive to shareholders

o    Today, management discussed two new share based compensation schemes to reward employees. As we understand it, the first consists of RSUs, which will result in immediate dilution to OZM shareholders of ~35mm shares, or 7% of the company. The second consists of P-Units, which represent 73mm shares (an additional ~15% of the share count), which appear to vest starting at a share price of ~$4.00.

o    Overall dilution has been meaningful historically: Since 2009, the share count at OZM has increased from ~400mm shares to ~550mm currently (not including P-Units)… this represents dilution of nearly 40% over 7 years

o    We believe the very high compensation ratios on performance fees, coupled with the significant dilution from the new stock plans are not favorable for equity investors in OZM

·         January Write-Up: “Our base case… would be a $5.60 stock”

·         Our View: It is extremely difficult to justify the stock’s valuation in a base case scenario

o    We believe the appropriate way to look at the valuation of OZM is as follows

§  Segment AuM by strategy, apply the appropriate fee rate to that strategy to determine Management Fee Revenues

§  Subtract ongoing expenses and a fair market cost of the preferred to arrive at Management Fee EPS

§  Assume an average future return on AuM and calculate OZMs share in earnings to determine Incentive Fee Revenues

§  Subtract cash bonuses to arrive at Incentive Fee EPS

§  Utilize a blended multiple of EPS for both management fees and incentive fees

§  Sanity check these EPS multiples using unlevered EV/EBITDA multiples

o    Below are our Base Case assumptions for EPS

§  Management Fee Revs of ~$320mm

·         AuM one-year forward is $33.5bn, flat with current levels

·         AuM is comprised of ~$14.5bn Multi-Strategy, $10bn Credit/RE, and $9bn CLOs

·         Blended management fee rate of 95bps (135bps Multi-Strategy, 88bps Credit/RE, 37bps CLOs)

§  Management Fee Expenses of $250mm

·         $150mm non-compensation expense (v guide of $140-155mm)

·         $100mm of salaries and benefits, ex bonus (v guide of $100-105mm)

§  Management Fee EPS of $0.06

·         7% pre-tax cost for the preferred interest expense

·         20% tax rate (v mgmt guide of 20-25%)

§  Incentive Fee Revs of $350mm

·         $24.5bn of incentive-fee eligible AuM ($14.5bn Multi-Strategy, and $10bn Credit/RE)

·         Returns of 6% for Multi-Strategy (average of the past 10 years for the Master Fund)

·         Return of 10% for Credit and Real Estate

·         20% incentive fee rate on the above

§  Incentive Compensation of $175mm

·         50% payout of bonuses relative to incentive fees

·         ~27% payout (excluding the $80mm minimum bonus cited above)

§  Incentive Fee EPS of $0.25

·         20% tax rate

o    Using a multiple of 14x for management fees, and 6x for incentive fees, we arrive at an implied share price of $2.30 for OZM

§  This represents ~30% downside from current trading levels

§  It is important to note that OZM would still carry healthy unlevered multiple at our target price

·         ~20x our estimate of EV to Management Fee EBITDA (~$90mm)

·         ~7x our estimate of EV to Total EBITDA (~$265mm)

§  Additionally, OZM currently trades at ~8% EV/AUM

·         It appears that the FIG/Softbank deal (announced last night) was done at 5% EV/AUM (including a 40% premium for FIG!)

§  It is also important to note that while we give OZM credit for 20% of profits in all funds (except CLOs) as incentive fees, Credit and Real Estate funds have preferred return hurdles (5-8%) which could significantly reduce incentive fees in those funds if returns are less than we forecast

§  Finally, we treat all bonus compensation as expenses under the lower multiple Incentive Fee bucket… If we were to include the $80mm of “base” bonuses in Management Fee expenses (which we believe is justified because these bonuses are paid regardless of performance), then true Management Fee EPS would be NEGATIVE

·         January Write-Up: “The Risk-Reward seems highly attractive at the current price”

·         Our View: The upside potential is not as attractive as it appears on the surface, and a downside scenario would be very difficult

o    Upside:

§  January Write-Up: “could see DE of $1.15, a 10x multiple (a discount to its 12x prior peak) and a $11 stock”

§  Our View: We believe that AuM would have to grow by nearly 40% from current levels to justify a share price of $6

·         Taking AuM to $47bn (back close to prior peak), and assuming the same multiples above,  it is difficult to get above $6 in valuation

·         This is due to 1) the multiple differential between management fees and incentive fees, and 2) the aforementioned mix shift in AuM away from the higher earning Multi-Strategy AuM

·         Also it is important to note that given the new P-Unit incentive plan described above, any upside in the share price would be met with further dilution… at ~$5.50 per share, it appears an additional 58mm shares (or over 10% of total) would vest

o    Downside:

§  January Write-Up: “It is not inconceivable that the business falls into a vicious cycle of poor returns, shrinking AUM, employee departures, etc”

§  Our View: Finally, something we agree on!

The author of this posting and related persons or entities ("Author") currently holds a short position in the securities mentioned above. The Author makes no representation that it will continue to hold positions in these securities. The Author is likely to buy or sell long or short securities of this issuer and makes no representation or undertaking that Author will inform Value Investors Club, the reader or anyone else prior to or after making such transactions. While the Author has tried to present facts it believes are accurate, the Author makes no representation as to the accuracy or completeness of any information contained in this note. The views expressed in this note are the only the opinion of the Author.  The reader agrees not to invest based on this note and to perform his or her own due diligence and research before taking a position in securities of this issuer. Reader agrees to hold Author harmless and hereby waives any causes of action against Author related to the above note.

Catalyst

future data points on AuM and earnings