oaktree capital an alternate asset manager to look at for the next financial crisis

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Oaktree Capital: An Alternate Asset Manager To Look At For The Next Crisis Jul 31 2013, 07:26 by: Mike Arnold

| about: OAK (Oaktree Capital Group LLC), includes: BLLAF.PK, BLLAY.PK

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Disclosure: I am long BLLAY.PK. (More...)

Oaktree Capital (OAK) is an alternate asset management firm, focused on finding and investing in low risk, high reward opportunities in less efficient markets including distressed debt. Oaktree prides itself on its investment mandate to seek out high risk adjusted returns:

Our investment approach, based on the primacy of risk control, and the strong risk-adjusted performance record it has produced appeal to the many investors who seek attractive returns with less-than- commensurate risk.

If you are like me, you are concerned about the next economic crisis. It's been almost 5 years since the collapse of Lehman Brothers and resultant world wide government intervention which has obfuscated the true underlying fundamentals of the global economy. A hard landing in China as a result of a credit crisis from it's "shadow banking system" and "entrusted loan" market could cause a massive ripple effect on the real economy, and potentially a significant correction in asset prices.

In times like that, distressed debt investing works the best. To illustrate how distressed debt investing can provide low risk, high reward opportunities, an informative example is gleaned from a recent investment by Oaktree in distressed Australian surfwear retailer, Billabong [(BLLAY.PK) (BLLAF.PK)]. I recently outlined why I purchased Billabong shares, and it wasn't because Oaktree had purchased the debt.

While Billabong has been a great trade for me so far, I was admittedly a little disconcerted when I learned that Oaktree had purchased Billabong's bank debt at a 10 - 20% discount to par value. In my mind, Oaktree was seeking a "loan to own" scenario where it would pursue a debt for equity swap, severely diluting current shareholders. Luckily, Altamont Partners came to my rescue and offered a refinancing package to pay off the debt owned by Oaktree, and an asset sale deal that leaves significant upside opportunity in Billabong.

It wasn't a bad month of work for Oaktree, however. It realized a quick 25% return, or 300% annualized (based on 20% discount and one-month holding period) with very low risk (the gain on its Billabong bank debt investment should be recorded in its Q2 or Q3 numbers). Billabong's equity price traded down to about an $80 million market value in June 2013, meanwhile net debt was only around $160 million. Meanwhile, Billabong generated in excess of $1.4 billion in sales last year, and is going through a restructuring whereby it is closing physical stores it owns, reducing costs and refocusing on its eCommerce distribution platform.

Needless to say, if Oaktree had been able to force a debt for equity swap for Billabong at those valuations, it would have provided its unitholders significant risk-adjusted returns as Billabong traded back towards its intrinsic value

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(which I estimate around $900 million).

With the experience of being at the mercy of Oaktree, I decided it might be better to invest some capital alongside them to achieve solid, risk-adjusted returns of my own, rather than holding subordinate equity claims on a business compared to owning the debt.

Considering the potential for an economic "black swan" environment in which we currently live, it may be time for investors to consider asset classes which are uncorrelated to the equity markets and which could significantly outperform given another crisis. In my view, that is exactly what Oaktree provides prospective investors: capital entrusted to professionals with a demonstrated track record of investment success, especially in the face of panic in the capital markets.

Oaktree Business:

Oaktree was founded in 1995, and has provided excellent returns for its investors over the course of its history (including $55 billion of distributions through its closed-end funds). Oaktree is led by Howard Marks, who is considered by most to one of the shrewdest investors of the generation.

Oaktree has a highly scalable business. It derives revenues and profits from an increased pool of assets under management ("AUM"). Since 2000, Oaktree has increased AUM from $17.9 billion to $78.8 billion at the end of Q1 2013, up from $77.1 billion at the end of 2012. The growing AUM base clearly indicates Oaktree's investing prowess and popularity among its investor base: in Q1 2012, Oaktree generated $3.3 billion in market value gains, $1.8 billion capital commitments for its closed-end funds, partially offset by $3.2 in distributions to investors of its closed-end funds. In no single year over the past six years has Oaktree raised less than $9.8 billion in gross assets, a record that is likely to continue in 2013.

Oaktree makes money in a couple ways.

First, it generates management fee's on $66.4 billion on "management fee generating AUM". Second, it generates incentive fee's based on Oaktree's investment performance on $34 billion of "incentive-creating assets AUM). If it sounds like there is some double counting going on, it is because there is. Some of the $77.8 billion AUM is carries characteristics of both management-fee and incentive-creating AUM.

Oaktree's incentive-creating AUM enjoys the standard 2 / 20 fee structure used by hedge funds, whereby management receives a 2% fee of AUM and 20% of any profits above its high watermark (in this case an annual preferred return, typically 8%). Therefore, Oaktree's managers have incentives aligned with their shareholders: better performance leads to increased profitability.

Should the capital markets become unstable in the future, Oaktree also has the benefit of $11.2 billion in uncalled capital commitments from its investors. That represents about 15% of the total AUM managed at the end of Q1 2013, providing Oaktree investment managers access to cash should certain distressed investing opportunities suddenly become available.

Valuation:

Oaktree is currently valued around $1.6 billion based on 30.2 Class A units outstanding, after enjoying significant price appreciation since its IPO in 2012. The price appreciation is deserved, given Oaktree's stellar performance in its first year as a public company (results discussed below).

Investors should note, however, Oaktree's fairly complex capital structure, which may result in Oaktree being put in the "too difficult to understand" pile. As part of a 2007 incentive restructuring Oaktree offered its limited partners shares in a holding company which provides certain conversion provisions to Class A units. Based on my read of the S-1 filing in connection with Oaktree's IPO, there are 116 million Class B units that could potentially be exercised and converted to Class A's, representing a total of about 150 million Class A units, fully diluted. If those shares are included in the market capitalization calculation, Oaktree's market capitalization would be closer to $7.9 billion based on ther current $53 quote. That would value Oaktree at about 10% of AUM. However, because Oaktree has shown ability to be a very good asset gatherer and strong investment returns, AUM should continue to grow at a steady pace.



(click to enlarge)

Of course, buying at higher prices (market caps) reduces potential returns and increases risk, but in my view, the underlying fundamentals of Oaktree support the equity price increase. I also see a hidden benefit of owning Oaktree, which is the likelihood for it to outperform other asset classes in the wake of another economic crisis, given its focus on low risk, high reward distressed debt investing situations.

In Q1 2013, Oaktree recorded $335.8 million adjusted net income (up 117% over Q1 2012). Revenues came in at $593.4 million on the back of a 422% increase in incentive income to $327.2 million (a record), on strong fund realizations and asset returns.

Here is a look at how Oaktree was positioned as of December 31, 2012 [source: Oaktree 2012 10-K]:

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Oaktree management and the "chief operating decision maker" use adjusted net income ("ANI") for resource allocation decisions, a non-GAAP measure, to calculate the incentive income, and to provide a measure to unitholders the ANI attributable to their ownership. ANI excludes non-cash equity based compensation charges for Oaktree units in place before the IPO, income taxes, expenses that each operating funds bears directly and an adjustment for Oaktree's non-controlling interest.

At a $1.6 billion valuation (non diluted share count), Oaktree trades at about 11 times last twelve months ("LTM") GAAP earnings, about 1.8 times LTM adjusted net income and at just 2% of its $78 billion AUM. All three appear to be conservative multiples given the strength in the returns and growing Oaktree franchise, even with the dilution issue. In my mind, the scalability of the Oaktree model justifies a premium valuation because of the low marginal cost of each additional dollar of revenue it derives from its AUM and incentive fees. Moreover, the fact that Oaktree could serve as an uncorrelated asset in a volatile and/or bear market, also helps justify richer multiples.



More reasonable multiples might be 15 times GAAP earnings, 3 times ANI and 3.5% of AUM, indicating upside between 36% and 67% from current prices, and considerably more if Oaktree continues its stellar investment results.

Another valuable asset held by Oaktree is a 20% interest in DoubleLine which is controlled by Jeffrey Gundlach, who has been called the "King of Bonds." Some believe Mr. Gundlach has the potential to grow its AUM to the size of PIMCO's fixed income portfolio which was measured at $2 trillion at the end of 2012, although Mr. Gundlach has stated $100 billion AUM is the target size of his funds. Currently, DoubleLine had $55 billion AUM at the end of Q1 2013.

Nonetheless, Mr. Gundlach appears to have considerable room to grow its asset base, and glean the resultant management and incentive fees.

Dividends:

Oaktree's dividend is variable each quarter based on its investment performance, which drives revenues and profits. Investors seeking steady or stable dividends, should understand then that Oaktree's dividend can and will fluctuate each quarter. Based on the last 4 distributions, it is clear that Oaktree continues to outperform:

Q1 2013: $1.41 Q4 2012: $1.05 Q3 2012: $0.55 Q2 2012: $0.79

Based on the last 4 distributions (cumulatively $3.80), Oaktree is currently yielding 7.1%. The yield, of course, will change based on the payout each quarter.

Investors are advised to not use certain investment websites which multiply the last distribution ($1.41) by 4, indicating that the annual dividend is $5.64 for a yield 10.6%. The dividend has and will continue to fluctuate and investors seeking yield and attracted to a 10.6% yield are encouraged to do more due diligence.

Risks:

In my view, the downside risk of owning Oaktree is quite limited at its current valuation. Because it's operating model is such that it derives substantially all its revenue and profits from its AUM and investment performance (incentive fees), the only risk is a broad based decline in the value of the assets it manages or massive investor redemptions. Both of these situations are unlikely considering the asset classes in which Oaktree invests (distressed debt, special situations, etc) which are typically low risk, high reward opportunities as seen in the quick profit made on the Billabong bank debt deal, and the fact that institutional investors, endowments and wealthy individuals continue to line up Oaktree's door to provide them capital.

According to management, Oaktree manages assets on behalf of many of the most significant institutional investors in the world, including 75 of the 100 largest U.S. pension plans, 38 states in the United States, approximately 400 corporations, over 300 university, charitable and other endowments and foundations, 10 sovereign wealth funds and over 250 other non- U.S. institutional investors. [1] That is a diverse group of investors, limiting Oaktree's risk of capital flight from any one dominate investor.

Conclusion:

You know what they say: If you can't beat them, join them.

Oaktree has a demonstrated track record of investment success over the business cycle, and particular acumen in distressed debt investing. Prospective investors seeking exposure to alternate asset classes that should behave in an uncorrelated fashion relative to the broad equity market should consider Oaktree.

Should the underlying fundamentals of the global economy falter, or asset prices suffer severe drops in price, Oaktree will be ferreting out low risk, high reward distressed debt investing situations to increase the value of their and your holdings in OAK.

Sources:

[1] Oaktree 2012 Annual Report, p. 35.



oaktree capital an alternate asset manager to look at for the next financial crisis

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