Description

Oaktree is a world-class asset manager trading at just 6-7x earnings net of the significant asset value it holds.  Better yet the reason for the mispricing is clear - the shares trade on "GSTrUE", the private OTC market launched by Goldman Sachs in 2007 that has failed to turn into a viable exchange (there is only one other stock that trades there, Apollo, and they are now trying to leave).  I believe Oaktree has largely been forgotten as a result, despite its business firing on all cylinders.  The stock is actually down since its 2007 listing despite the company's AUM almost doubling and its earnings growing more than 150% over that time.  The company has strong growth prospects and benefits from the operating leverage inherent in asset managers, but also affords defensive characteristics typically not available in the sector - its business model is counter-cyclical given its focus on distressed debt and track record of raising capital during turbulent markets, most of its capital is locked up for many years (63% of AUM is in 10-11 year PE vehicles), and it has significant asset value on and off its balance sheet (39% of its market cap is represented by investments in Oaktree funds and profits it has already earned but not yet accounted for - more on that later).  The management team is top-notch and the entire firm is rooted in a bottoms-up, value investing mindset.  The big caveat is where the shares trade, and you have to be a qualified investor to sign up for GSTrUE (call the client service desk at 212-357-9700 for more info).  While it trades by appointment, if you're patient and don't mind paying a bid/ask there is liquidity available (~15% of the company is listed, about $800 million total). 

Despite the messy listing structure I believe this is a very attractive situation for the patient investor who can wait for the gap between price and value to close, and benefit from that value compounding in the meantime. As a comparison traditional asset managers trade over 20x earnings on average and alternative asset managers are in the low double digits.  On an EV/AUM basis, Oaktree trades at 4.2% (after adjusting for the company's asset value), while its peers in the alternative space average over 10%.  Traditional asset managers, who have far inferior business models and fee structures, trade at 2.5% of AUM on average.  Since Oaktree is not only an alternative manager, but one of the very best, I believe that if the stock were to leave GSTrUE for a larger exchange it would at least trade closer to the range of its alternative peers.  Management has been vague about when that might happen, but has said that an eventual change is inevitable as they are concerned about their own liquidity and that of their employees.   

Company Overview

Most of you are likely familiar with Oaktree so I'll keep this part brief.  The LA-based company manages $78.9 billion in assets across a large number of funds and strategies, but with a particular focus on distressed debt.  The core team, led by Howards Marks and Bruce Karsh, has been together since the 80's and spun out of TCW in 1995 to found Oaktree.  The team has been a pioneer in various strategies and performance has been outstanding over a long period of time - for example the flagship distressed strategy has generated an 18.8% net IRR to clients since 1988.  The funds are largely unlevered and run in a conservative manner, designed to outperform in down markets and hopefully keep up during good times.  This held true during the recent crash and subsequent rally - across its funds Oaktree was down 20.7% in 2008 and up 38.9% in 2009 - outstanding performance that has helped it raise over $50 billion in new capital and commitments since 2007. 

If anyone has not read Howard Marks' memos to clients, they are available to the public online and I would highly recommend them whether you are interested in Oaktree stock or not: (http://www.oaktreecapital.com/memo.aspx).  What is clear from the letters is that the management team truly "gets it" and runs the business in an investor friendly, long-term focused manner.  They raise less capital when opportunities are scarce, don't take deal fees for themselves, and only take the carry at the end of a fund's life.  While this may not maximize short-term earnings, this approach has earned the firm an outstanding reputation with clients and is likely to continue to payoff over the long run.       

Valuation

The table below compares the company's #'s when it listed in 2007 relative to today.  It is a good example of the operating leverage that asset managers have due to their largely fixed costs - when AUM goes up profits usually go up even more.  Another key to the story is the asset value Oaktree has built on and off of its balance sheet.  The on balance sheet assets include $1 billion of investments in its own funds, representing almost 20% of the market cap.  The off balance sheet asset is a result of Oaktree's conservative accounting policies - unlike its peers, Oaktree only recognizes its incentive fees as actual earnings when capital is returned to investors at the end of a fund's life, as opposed to when the underlying positions are simply marked up.  Oaktree keeps tally of those "accrued incentives", which currently total $1.8 billion.  If all of its funds shut down today that would result in $1 billion of income for Oaktree shareholders.  While in reality the accrued incentives will get realized over a number of years, and the total is likely to grow in the meantime, it's still nice to know that if the company unwound everything today there would be almost $2 billion of value remaining for equity holders, or 39% of the current market cap.    

It's worth noting that Oaktree's P/E is not quite as low as the table above suggests - those #'s are for the entire company (85% of which remains unlisted), and the listed portion does have some additional costs and taxes that eat into its earnings a bit.  EPS of the listed shares for the last 12 months is $3.85, so the headline valuation is 9.2x earnings.  If you exclude the balance sheet investments you are paying 7.4x, and if you also exclude the earned but not yet recognized profit from the accrued incentives you are paying only 5.8x.    The company also pays out around 75% of its distributable earnings as dividends. While the quarter by quarter numbers can fluctuate, over the past 12 months Oaktree has distributed $2.17/share, equating to a 6.1% yield.   The firm also bought back $4.7 mm of its own stock in 2009 at $14.30/share, close to the all time lows. 

Mix of Earnings

Oaktree generates revenue three ways - management fees, realized incentive fees, and from gains on its own investments.  While the management fees are steady, the incentive and investment gains can fluctuate greatly depending on fund performance.  Margins can also fluctuate since investment gains are extremely high margin, while incentive fees are split with the team (roughly 45% goes to comp).  While that means it is impossible to precisely predict Oaktree's quarter by quarter earnings, the long-term earnings potential is huge if the firm can continue to raise assets and generate strong returns.  At current levels the management fee stream alone largely justifies the stock price, and you get the incentive fees and investment gains as upside.  The company is very profitable off of its management fees alone and has only recorded one quarter since its 1995 founding without a profit (Q4 08), when it lost $11.5 million due to $114 mm in write-downs in its investment portfolio.    

Comps

Oaktree also appears quite cheap relative to its asset management peers, particularly given the quality and diversity of its business.  Oaktree does have a somewhat lower all-in fee rate than the other alternative groups (largely from its marketable business and the 8% hurdle on its private funds), although its asset growth has been amongst the best in the group.  While the other alternative firms typically do have investments in their own funds, they do not have the large pool of accrued incentives on the side, as they recognize those as earnings right away instead.  The P/E numbers below do not take any of the companies' asset values into account, but are rather the headline numbers.     

Asset Raising and Future Growth

Oaktree has a great asset raising track record (it's worst year ever being its first, when it "only" brought in $2.4 B in 1995) and was extremely well situated to raise capital during the recent crisis.  2007, 2008, and 2009 were its three best years ever on that front, bringing in between $12-$19 billion/year.  This counter-cyclical dynamic is important and sets Oaktree apart from most asset managers, who are typically just levered bets on the underlying markets in which they invest.  Oaktree on the other hand is able to grow its asset base significantly during bad markets, and in good times should still generate strong earnings from realizing gains and incentive fees on the assets purchased near the bottom. 

Oaktree has an impressive roster of deep pocketed clients, including 68 of the largest 100 US pension funds, 38 US state plans, 45 sovereign wealth funds and non-US pensions, and around 300 endowments and foundations.  The sovereign wealth market in particular should be a large area of future growth given the significant asset growth in the space and desire to invest with large, blue chip firms like Oaktree.  While it might not be entirely rational, and most of us on VIC would agree that size is the enemy of performance in investing, capital continues to flow almost entirely to large funds and that trend should continue to benefit Oaktree.  To quote an article a few months ago from Dow Jones: "Hedge fund investors allocated nearly all of the $23 billion in new capital (during Q2) to managers with over $5 billion assets under management, according to Hedge Fund Research".   The old saying "nobody ever got fired for buying IBM" definitely applies here, and Oaktree is similar amongst asset managers - a blue chip, safe bet for large institutions to invest with. 

Of Oaktree's current assets, $49.6 B are in private partnerships (PE funds), $25.7 in marketable funds (mutual fund type products), and $3.6 B in hedge funds.   The marketable funds typically charge a flat management fee around 50 bps and have 30 day liquidity.  While this provides a nice recurring revenue stream, and assets there have been quite sticky even through the crisis, the majority of the long-term value in Oaktree is in the private partnerships.  These typically have 10 to 11 year structures with a 1.5% management fee and 20% incentive over an 8% hurdle.  The share of the firm's AUM that these partnerships represent has steadily grown - for instance in 2007 Oaktree had $14.8 billion in incentive-creating AUM, which was 28% of total assets, and currently has $37.4 billion worth which is 47% of assets. 

Oaktree's performance across funds has been truly outstanding.  Its funds have outperformed their benchmarks over long periods of time while taking significantly less risk and generating much higher sharpe ratios.  Its main funds are listed below, with performance through year-end 2009 included:

Oaktree has increasingly become a global firm in recent years, with 24% of its underlying investments coming overseas, 30% of AUM from international investors, and 30% of its team located abroad.  While the overall opportunity set is nothing like a couple of years ago, there still should be plenty to do in the coming years - Oaktree is excited about commercial real estate and European distressed in particular.  Oaktree was also one of 11 firms selected by the government to participate in the PPIP program last year, out of well over 100 that applied, and raised the third largest fund of the group.      

Risks

I view the main risk here as time.  This stock could trade sideways for a good while if no action is announced to get off of GSTrUE, and could certainly go down temporarily if the markets fall.  An investment in the equity is also dependent upon Oaktree raising assets in the future as well, especially since its current private funds will liquidate over time - given Oaktree's reputation, performance, and consistent asset raising up to this point I view that as a minor risk.   There is always key-man risk with asset managers as well, although Howard Marks and Bruce Karsh are 63 and 54, respectively, and show no signs of slowing down or leaving anytime soon.  Oaktree has experienced impressively low turnover over the years for such a large firm, and 152 different employees own equity in the business.  Finally there is likely mark to market risk for the equity - if the markets fall significantly Oaktree's balance sheet investments and accrued incentives could drop in value, and thus earnings would fall as well.  Fortunately that would present another golden opportunity for Oaktree to do what it does best - raise capital to buy distressed assets when everybody else is selling.      

Catalyst