Wednesday, April 25, 2012

OAK: Oaktree Capital Management IPO

Oaktree Capital Managment had their IPO recently (April 12?); the stock was offered at $43.00/share but is now trading at $39.41 (today's close).   The price range for the offering was $43-46 so it came it at the lower end, and the planned 10,295,841 share offering was reduced to 7,888,864 shares (excluding the shares sold by current shareholders).  All of the proceeds are to be used to buy out existing shareholders (or partnership units).

I'm not going to go into the details here because Oaktree is a bit complicated like all of these publicly listed hedge fund/private equity fund management firms, but I'll cut and paste (snip function on Windows 7) a bunch of interesting looking charts from the prospectus and also take a stab at valuing OAK.  (OK, it was co-lead by Goldman Sachs and Morgan Stanley if you must know.  They earned fees of $17,781,635 on this deal that comes to a gross spread of 7%.  I guess Oaktree doesn't have the negotiating power of a Facebook... A $380 million offering is not worth a discount).

Oaktree is very interesting because it is founded and run by Howard Marks, who is just about the best in the business with respect to fixed income investing.  He specializes in distressed debt and has a great track record.

He has also written what I think is one of the best investment books out there today; The Most Important Thing:  Uncommon Sense for the Thoughtful Investor.   Buffett's blurb on the cover says, "This is that rarity, a useful book".

Other people who wrote blurbs on the back cover are Joel Greenblatt, Jeremy Grantham, Seth Klarman and John Bogle.    That tells you Marks has written a pretty good book, and it is a really great book.

I have been reading his letters to investors for years (I'm not an investor in his funds, but read it when it floats around on the internet), and he is one of those people who are no nonsense and spot on.

Some basics are that they have $75 billion in assets under management as of December 2011, has 650 employees in 13 offices around the world and it was founded in 1995.

The asset breakdown by strategy is:

Distressed debt:  32%
Corporate debt:  28%
Control investing:  23%
Convertibles:  10%
Real estate:  6%
Listed equities: 1%

Anyway, here are some interesting charts from the prospectus.

The Alternative Asset Management Business
Like all the other alternative asset managers, the prospectus describes the industry and it's bright prospects.

This may disagree with Buffett's views that he doesn't think any hedge fund, after fees, will outperform the S&P 500 index over 10 years (he made a bet with someone on that; this bet is still ongoing so there is no winner yet).
The graph below shows that alternative investments have outperformed traditional investments over the past ten years.

This, and similar graphs are used by alternative managers to raise capital.  It is not surprising that these alternatives have beaten the S&P 500 index over the past decade, as the past decade has been pretty bad for stocks and hedge funds tend to do well in volatile markets.

This graph also worries me a little bit.   I always worry when pensions rush into any certain asset class.  This is totally understandable given that we've had TWO big bear markets where the S&P 500 index went down 50% in the past decade; it's been a high risk, no return market.  People want returns.  They don't want 50% bear markets and flat returns.   Also, many pensions assume an 8% return on plan assets and if they don't achieve it, they may have to contribute cash to it causing a hit to earnings. 

They would much rather reallocate the pension funds away from stocks and bonds (low return assets) into alternative assets which promise such high returns.

This sort of thing *always* cause trouble.  

I think this is also one of the reasons why equities remain reasonably valued:  there is an ongoing reallocation out of equities into alternatives.  People just don't want stocks.

Anyway, this has nothing to do with OAK, so let's go on.

Assets Under Management

Like other hedge funds and private equity funds, OAK has really grown their assets under management (AUM) dramatically in the past decade.  As usual, my primary concern would be if they can perform just as well with $80 billion in AUM as they did when they managed $20-30 billion.   Size really cuts down on the choice of investments.   Some of this is tempered by going global; when the universe is expanded, so should the opportunities.  But still, it gets tougher to get high returns with higher amount of capital.   I don't think there is a way around that.


The returns on their distressed debt strategy has been pretty stellar.  The gross internal rate of return on their closed-end funds (not to be confused with publicly listed, perpetually discount-traded, poorly performing closed-end funds) was +19.4% and +22.9% for the distressed debt strategy.  These are nice returns, but that's to be somewhat expected as it is a distressed strategy where equity-like returns are expected (in this case, it's way better than equity-like returns!).

One thing I should mention is that these IRR's are a little different and not directly comparable to other hedge fund, mutual fund returns.   I think these IRR's are calculated on capital actually employed.  This means that if you raise a $1 billion fund, the investors don't have to put up the capital until you call it.  And you don't have to call it until you find an investment.  So if the $1 billion is not deployed in the first year or first few months or whatever, that doesn't affect your IRR.

Once you invest it, then the IRR calculation starts.  But if you are a hedge fund and you raise $1 billion, then your performance is going to be tracked on day one.  If you own only cash, then you made zero return on day one.  If you do nothing for a year, this will negatively impact your annual returns.  This is the same with mutual funds.

For private equity and many of these 'closed end' funds with terms, that is not the case.  Obviously, the IRR will be much higher than with other types of funds as you are not penalized for the cash or undeployed/uncalled capital.

The following is a composite return chart of the high yield bond strategy.  Since 1986, the strategy has returned 1069% versus 776% for the benchmark.   So that's 10.3%/year since vs 9.1% for the benchmark index.

Here is the return on specific funds compared to the default rates of non-investment grade debt at the time of the launch.
You will notice that the funds launched in bad times have the highest returns versus funds that were launched when defaults were at a low point.  Oaktree understands this very well so tries to adjust their capital raising to be counter-cyclical; raise more money in bad times when prices are cheap, and less in good times when prices are high. 

Below is a graph that shows how they deployed very little capital in good times while the private equity industry was falling over themselves buying stuff up, and then when things blew up, Oaktree stepped in to buy and private equity fund capital deployment plunged.

This really illustrates the counter-cyclical nature of Oaktree.  They act when prices are low and their performance is improved by that.  They clearly don't follow the crowd.  We can see with these figures that Oaktree really walks the talk; they do what they say they will do (and what Marks says investors should do in his book).

The following is the breakdown of revenues since 2000:

So you can see that like other similar listed hedge funds and private equity funds, the three pillars of revenue are management fees, incentive fees and investment income.

So What is OAK Worth?
As usual, here's the tough part.  What the heck is this thing worth?  We know that the value of Oaktree comes from the three sources of revenue shown above. 

So OAK is worth the sum value of these three parts:  some stable revenue/income based on management fees, the assets they own on their balance sheet which is cash, treasuries and investments in their own funds (and some other assets, but most of the assets are financial assets), and the option value of the incentive income.

The ownership structure is complex and the financial statements can be quite confusing.  So I will ignore all the confusion and assume that only one class of  stock is outstanding and that represents the equity in the whole firm. 

According to this simplification, OAK would have 148,524,215 shares outstanding (never mind if it's class A or class B or whatever class.  I think this is what will be outstanding if all the partnership units, class B and others is converted to class A, which is the listed class).

The financial statements are confusing too because accounting rules force them to consolidate assets in certain of their funds even if that doesn't make much sense.  And then the balance sheet/income statement shown with consolidated fund assets/liabilities and income/expense shown separately is confusing too as OAK does own shares in some of their funds which shows up in the portion of assets on the balance sheet in the "assets of consolidated funds" (which would include assets that actually is owned by OAK).

So Oakmark has a separate table somewhere else that shows segment income statement and balance sheet which sorts all of this stuff out and puts what Oakmark owns in the operating segment.

OK, that's kind of confusing, I know.

Anyway, let's take this one piece at a time.

Fee-Related Earnings
Fee-related earnings (FRE) is a convenient measure that shows us what the business will earn on a steady-state basis with no investment returns or incentive fee income.  It's basically the management fee revenue minus compensation and benefit expense (excluding bonuses tied to incentive fees) and general and administrative expense.  

If you are running an asset management firm, this would be a key indicator.  Basically, you want to be able to cover all of your fixed cost with management fees, and if you can make positive earnings, that's even better.  This leaves the incentive fee income and investment income as bonuses, or icing on the cake.  You don't ever want to be in a position where you have to make good returns and earn incentive fees just to cover expenses (or depend on investment gains on from your balance sheet). 

The FRE for the past five years were:

             FRE  ($mn)
2007      $119
2008      $256
2009      $290
2010      $375
2011      $315

Over the past five years, FRE averaged $271 million and for the last three, it was $326 million. So what is normal here?  This is the problem with valuing businesses.  FRE and AUM has grown in the past few years, but is that because of the financial crisis and many great opportunities, or is the AUM trending upwards on a secular basis for the long term? 

If this growth is secular, then using $326 million as a base-case FRE figure would be fine.  If current AUM is bloated due to the financial crisis and extraordinary opportunities that arose in the past couple of years, then it may not be. 

So let's just use the figure in between and call FRE $300 million per year.   The other big question is what multiple you put on this.   I will use a conservative figure (what I consider conservative, of course, may be silly to others; anyone can use their own multiple).   I will use a figure of 10x this pretax figure.  10x is a 10% pretax coupon and that is very reasonable in this environment. 

At 10x the pretax income, the value of the FRE flow comes to $3 billion.  With 149 million shares outstanding, this is worth $20/share

Their management fees for funds is 1.48% for closed end, 0.47% of open end and the overall (including Evergreen funds) management fee is 1.11%. 

So if they maintain AUM at current levels and expenses remain the same, they can earn $315 million (same as 2011) on an ongoing basis.  I do think that management fees will actually go up going forward as increasing expenses in the past few years are due to expanding the business (international etc...).  If this is the case, AUM may rise.  If it doesn't work out, we can expect expenses to come down. 

(Actually, FRE is taxed at the corporate level at OAK so after tax and per share FRE can be found at in the prospectus (but only for 2009-2011).  After-tax FRE per class A share were $1.30, $1.75 and $1.47 in 2009, 2010 and 2011. Put a 14x p/e on that and you get $18.20 - $24.50/share value.  The average for the three years was $1.50.  At 14x $1.50, you get $21/share in value.  But it's the same valuation (10x pretax = 14x after tax etc...).  

Balance Sheet Value
OAK owns cash, treasuries and investments in their limited partnerships (funds) among other things.  They also have debt and other liabilities.  One quick way to measure their balance sheet value is to look at the tangible book value per share listed in the prospectus.  That's $7.44/share proforma after the offering.  This is a quick proxy because most of the assets at OAK is in financial assets such as the above. 

Of course, this may be double counting to some extent if there are assets used in the asset management business itself.  To prevent that (and I don't know the details of 'other assets' and total liabilities), we can just be very conservative and add up the cash, treasuries and investments and subtract total liabilities so that we can be sure we don't include assets that help generate income other than investment income. 

Here's the balance sheet summary from the "Segment Statements of Financial Condition":

Cash and cash equivalents:                                       $297 million
U.S. Treasury and government agency securities:   $382 million
Investments in limited partnerships at equity:          $1,159 million
Total investments and cash:                                     $1,838 million

Total liabilities:                                                      $ 960 million
Net cash and investments:                                   $ 878 million

With 149 shares outstanding, that comes to around $5.90/share.  So that's only off by $1.50 or so from the tangible book value per share.  I don't know exactly what the difference is as the balance sheet asset items listed on the Segment Statement of Financial Condition doesn't add up to the Total assets figure (only the financial assets are itemized). 

So let's just say that $5.90/share in net cash and investments is conservative as the asset side really does include only the financial assets and we deducted all liabilities from that. 

Incentive Fee Income
So what does that leave?  The last piece of the valuation puzzle is basically the incentive fee income.  Incentive fee is generally 20% at Oakmark and 40% to 55% of that is allocated (when earned) to incentive fee-linked bonuses.  So what is left over to Oakmark after paying bonuses on that is somewhere between 9% and 12% of fund returns.

There are a lot of ways to look at this but let's look at the first, simplest one.  Incentive fees are obviously lumpy, so let's just look at the average incentive fee income for the past five years: 

                              net of incentive compensation (bonus)
2007   $332           $254
2008   $174           $109
2009   $175           $109 
2010   $413           $254
2011   $304           $125

The average is $280 million through this period.  It would be $170 million after incentive based compensation.   

How do we value this?  Just using 10x pretax income, that would value the incentive fee stream at $1.7 billion, or $11.40/share.  But one important point is that the incentive fees earned are booked using a more stringent standards than other funds; there are accrued incentive fees that are not on the balance sheet and does not pass through the income statement. 

Apparently, this is a choice by management so as to reduce the volatility of earnings (by booking earnings on accrued incentive fees, this may cause volatility as market declines can force a reversal of these accrued fees). 

So we would have to add back the balance of accrued incentive fees (net of associated incentive compensation (we can get the same result simply by adding incentive income to incentive created instead of just using incentive income). 

The balance of accrued incentive income (net of bonuses) was $1 billion at December end 2011.  So that $1 billion comes to $6.71/share

So the incentive fee stream (including accrued incentive fees) comes to $18.10/share.  

Of course, there is a problem with just using the average incentive income for that past five years as incentive creating AUM has grown from $15 billion in 2007 to $36 billion.   I suppose it is conservative in that sense. 

Just as a sanity check, let's look at it another way.  Incentive fee, or carried interest is sort of like having a direct equity interest in the funds (except that you don't have to participate on the downside). 

As we said above, we know that incentive fees are 20% and 40%-55% of that is paid out as performance bonuses to employees, so what is left to OAK is something like 9-12% of the fund returns (assuming they can earn more than 8%). 

So another way to look at this is to assume that OAK owns 9% of the incentive fee generating AUM.  That figure is $36 billion at December-end 2011.  9% of that (to be conservative, I will use the lower portion of 9-12%) is $3.2 billion.  That comes to $21.50/share.   Of course, this is just a rough estimate.  The good thing about this approach is that you don't have to make any assumptions about investment returns.  The bad is that it doesn't take into account the fact that OAK will earn no incentive fee if they return 7% (or anything lower than the preferred return rate of 8%). 

As another cross-check, let's just say that the funds earn 10% gross returns.  That would generate $3.6 billion in profits at the funds and an incentive fee of $720 million and net of incentive compensation $324 million.  Slap on a 10x multiple on that pretax number and you get $3.2 billion or $21.50/share

So we come to the same valuation as the above.  

Summing the Parts
So putting those pieces together, we have: 

Management fee value per share:          $20.00
Net cash and investments per share:        $6.90
Incentive fee value per share:                $21.50
Total value per share:                          $48.40

(I used $21.50 because two approaches converged on that number and it makes more sense since it uses the more recent AUM number). 

So with the current price at $39 or so, OAK appears to be trading at a discount of 20%.  This is a really simple analysis and I may be missing something (or a lot!), but I think this sums up the gist of the value in OAK.  You can use your own multiples to see what you come up with.

As a final sanity check, I thought about looking at the adjusted net income per share of OAK over time and distributions per share.  But I realized it may not be that meaningful as although adjusted net income is a very good measure of the economics of the operating business given the complexity and non-cash expenses, it doesn't include accrued incentives so understates earnings.  

The above approach allows us to plug in our own numbers and multiples on each piece of the value so I am more comfortable with this sort of analysis rather than slapping a multiple on a single earnings figure, particularly when it's so easy to separate out the value pieces. 

Anyway, this is just a quick look at this thing.  I will keep an eye on it but am in no rush to go out and buy OAK at this point.  As usual, I am concerned about the rapid growth in AUM and what it will do to prospective returns on their funds and whether they will do as well internationally.  One well known thing, at least until recently, is the legal clarity and structure in distressed situations in the U.S. versus other countries. I remember distressed investors having trouble in Japan, for example, since there wasn't a clear legal route to value realization like there was in the U.S. 

I can be confident in the honesty and integrity of the folks at OAK.  I would never worry about that. Their philosophy and approach too makes a lot of sense and I would be very comfortable with that. Read the beginning of the prospectus; it is well worth reading to get a feel for who these people are. 

And obviously, Howard Mark's book is also pretty much a must read for value investors and you will get a feel for how this firm is run. 


  1. They are also holding their 22% stake in DoubleLine at CONSIDERABLY less than its true value. At $30b AUM and rapid growth, a 2% Equity Value / AUM is fair, valuing this business at $600m. That would be $132m to OAK

    1. Yes, thanks for that. My figures don't reflect that but income from Doubleline Capital LP flows through the "investment income" line in the OAK income statement so it does show up as earnings there.

  2. Thank you for writing this. Since the stock has dropped almost 20% after IPO, I thought it warrants a second look. The IPO prospectus is hard to parse so I am grateful for the guidance your post provided.

    Here are a few thoughts I have on this one (hopefully they can contribute to the conversation).

    - With the drop in stock price, the company is now worth ~$5.2B. So with $1B capital and $1B of accrued net incentive fee of $1.2B, you only have to put a value on the future income stream based on ~$3B valuation. I think valuing the company at $300M per year at 10x multiple pretax is a good value. Comparing to other similar companies like Avenue capital or Apollo, the 1% mgmt fee seem to be competitive.

    - The company brought back stock at $35 and a few others smart money like greenlight, scorggin, davis have all invested which is good sign. I think you should be pretty safe following these guys.

    - I am not sure about the stock vesting cost. Its a big piece resulting in ~1.5% share dilution and is accounted as ~$900M cost in each of the last 3 years . I don't know how to interpret the "consolidated statements of operation" at all, so I don't really understand how this cost impact the valuation. Any idea how this should be viewed?

    - The distribution to class A holders suddenly jumped in 2010 and I couldn't find a reason what drove that. The distribution last quarter is above the mgmt fee earned so it can only be sustainable if incentive income and investment keeps up.

    - I think this should be a pretty sticky business because I don't think you can just create a index based ETF that will do nearly as good. However, this is definitely a business that require a smart team on top so its not a idiot proof business.

    1. Hi, I agree this is an interesting stock, and more so now that it's cheaper. You can ignore the $900 mn stock vesting cost as that is something related to the "reorganization" and is a non-cash charge to account for something that happened in 2007 (created new entity OCG and exchanged OCG stake for old ICM partnership units). 2012 should be the last year this takes place so it is irrelevant for analyzing the company.

      As for the distribution, I don't know what drove the rise; I think it's pretty variable so they will pay out what they think is right. I wouldn't worry about that too much as I think the key is going to be distributable earnings and ANI.

      I would basically ignore consolidated stuff because accounting rules force consolidation of funds Oaktree manages. This can get really messy and misleading. This is why they present their segment data the way they do. I would pay attention to that.

    2. Yes, I was looking at the segment data but it bothers me that I couldn't correlated back to the consolidated statements. I don't know wither to hate the fact that their prospectus is so convoluted or cheer them for not simplifying things just to marketing their shares to the investor.

      Thank you for helping me understand the 900M stock vesting thing. They are still doing small RSU issuance for performance incentive. In the march 31 quarterly statement, it still showed "Issuance of Class B units" of 2.313M shares which works out to be $81M worth viewed simplistically based on $35 share price. But this can be absorbed into the expenses pretty easily.

      I believe Bridgewater is ~$120B and I don't think oaktree can be compared to something like PIMCO. So in my view I think its hard for the AUM to grow more. Then based on the $60-80B AUM, you would be looking at a $250-400M FRE which should be pretty consistent. So I think you can probably get 5-6% cash distribution payed out consistently plus the upside of any incentive income. Would this be a correct way to view things?

    3. Hi, I think that sounds about right. AUM is hard to project as these guys don't want to grow AUM in good times unless prices are good; they are sort of counter-cyclical in that sense.

      But yes, the best way to look at this is to find a steady-state FRE figure as the 'core' value/floor and then anything above that is a bonus. That doesn't mean we should value incentive income and investment income at zero, of course.

  3. Thanks for this analysis--Probably the best I've found. I've got a couple of questions if you have the time:

    Page 14 of the prospectus shows net income losses every year, but their ANI/ANI-OCG (and everyone's analysis) shows positive income (e.g., at page 105). Page 107 does the reconciliation, but I'm not getting why GAAP's "compensation expense" (which is admittedly non-cash) causes the profit to go to a loss. I'm still digging, so perhaps I'm being dense.

    Also, this bothered me a lot (page 55):
    As long as 90% of our gross income for each taxable year constitutes qualifying income as defined in Section 7704 of the Code and we are not required to register as an investment company under the Investment Company Act on a continuing basis, and assuming there is no change in law (see “—The U.S. Congress has considered legislation that would have taxed certain income and gains at increased rates and may have precluded us from qualifying as a partnership for U.S. tax purposes. If any similar legislation were to be enacted and apply to us, the after-tax income and gain related to our business, as well as the market price of our Class A units, could be reduced.”), we will be treated, for U.S. federal income tax purposes, as a partnership and not as an association or a publicly traded partnership taxable as a corporation. As a result, our Class A unitholders may be subject to U.S. federal, state, local and possibly, in some cases, foreign income taxation on their allocable share of our items of income, gain, loss, deduction and credit (including our allocable share of those items of any entity in which we invest that is treated as a partnership or is otherwise subject to tax on a flow-through basis) for each of our taxable years ending with or within their taxable year, regardless of whether or not our Class A unitholders receive cash distributions from us.

    This whole paragraph seemed quite odd to me--normally, US is only taxed on gains or dividends, but the above seems much more like a partnership set-up. In that case, is it partnership type IRS filings and not a stock?

    1. Hi, the non-cash compensation is mostly the non-cash charge related to the 2007 restructuring. OAK did some sort of exchange with the original partners and this exchanged was basically marked to current value which was large. So that 'grant' of shares or units to the old partners is considered compensation and is written off over time (I think five years). So for valuation purposes, this can be ignored. No cash ever left and no cash will have to leave.

      As for the p. 55 paragraph, it just means that they don't have to register as an Investment Company as long as they don't look like a fund; most income is not capital gains, dividends and interest income.

      If they are deemed an investment company, then they have to follow the Investment Company Act of 1940 rules and post NAV on a daily or weekly basis and do other things that closed end and/or mutual funds have to do. This is a huge hassle, so companies that are not funds have to be careful not to fall into being called an investment company.

      As for the legal structure, this is an LLC so it's not a corporation. LLC is basically a partnership (even though it's a hybrid). But as an investor, it's basically a partnership as you will get a separate K-1 form and you will have to report the pass-through income (and expense) on a Schedule C unlike a stock where you just report dividend income. So your tax liability may be higher than the cash distribution paid out by OAK.

      It is a hassle, and when you do invest in something like this, oftentimes you won't be able to file your tax on time (as many K-1's come too late). But if you file an extension, that's not a problem...

    2. thanks for your reply--I've been reading a fair amount about these set-ups this morning, (e.g., looking at blackstone as a model). It seems as though I would expect the distributions and income reported on the K-1 to be around parity. For that income, presumably it is at my marginal tax rate? I'm having trouble figuring out what kind of income will be passed through, so would appreciate any input if you are aware.

      I do note that you said "most income is not capital gains, dividends, and interest income", but I'm not sure if I'm parsing the "not" correctly--sorry if you were already answering the above.

    3. For normal profits, I think the K-1 income is taxed at your ordinary rate. In the K-1 income might be some interest income, capital gains etc... and thay may pass through at those rates for you too.

      You are right that the cash distributions should usually cover tax liability but that may not always be the case depending on what the company wants to do. I don't know enough history to know how these things usually work out (this is a relatively new structure for asset managers, at least in the listed world).

      As for my comment about capital gains, dividends and interest income, that's just for the definition of an investment company. You can google it, but if most of your income (at the company level) is passive investment income, that might make you an investment company. Also, if most of your assets are in investments etc... That's what I was referring to.