Friday, February 15, 2013

Solid Results at Oaktree, But...

Oaktree Capital Group (OAK) announced pretty good earnings for the full year of 2012.  The funds, across the board, returned around 15%.

For those who don't know, OAK is co-founded and run by Howard Marks, a legendary Buffett-like figure in the fixed income world.  It would be well worth your time to google Howard Marks and read his "memos" and watch youtube and any other video interviews you can find on the net.  He also wrote a fantastic book, The Most Important Thing: Uncommon Sense for the Thoughtful Investor.

Anyway, I'm not going to repeat all the stuff that you can get from the earnings release.  If you're interested, you can just go to the OAK website and read about revenues, adjusted net income, distributable earnings, economic net income and all of that.  I'm just going to look at some things that made me raise my eyebrows and then maybe take a quick look at valuing this thing at the end.

I did happen to pick up some OAK last year as it tanked after the IPO so I am sitting on some nice profits on this position but it doesn't feel as much like a no-brainer that it did last year.  Anyway, I am getting ahead of myself.

No Longer Counter-cyclical?
The first thing that made me raise my eyebrows is that on the conference call, Howard Marks said that in 2012, they raised $12 billion in capital for funds which was their sixth year that they raised $10.8 billion or more. 

I thought, great!  That's really fantastic.  They are on fire!

But then I thought, wait a second.  I thought these guys were counter-cyclical.  I remembered a graph they had in their S-1 (prospectus) last year that really impressed me.  Here it is:

So in 2006, while private equity investors fell over each other investing, Oaktree Distressed Debt funds were laid back and not doing much.  The same happened in 2007.  But then when the wheels fell off, Oaktree pounced and made a lot of investments while private equity scaled back dramatically.  See how investments ballooned from $1.5 - $2.5 billion in 2006-2007 to $9.9 billion in the 4Q08-3Q09 period.

OAK can raise a lot of funds to maximize management fees, but this is not who they are.  They won't raise funds just to earn fees. 

But then we see that OAK has raised more than $9.8 billion for the sixth straight year in 2012.  To be clear, the above table is only for the Oaktree Distressed Debt funds and not for all of OAK.  In recent years, they have been adding different strategies (real estate, Europe etc...) so it's not apples to apples (plus the above table is for capital invested, not capital raised).

But still, with default rates and high yield spreads at historical lows, it's hard to imagine where all of this capital will be invested.  I don't mean to second guess Howard Marks or the smart folks at OAK.  They are the pros.  I'm an equity guy so have no clue about fixed income markets.

It seems to me, though, the combination of low nominal interest rates and low credit spreads around the world is at a historical level.  It's hard to imagine how they can earn good returns going forward in this market.

Marks did say on the conference call that he thinks they can still earn 10% returns over time. This was in response to a question of whether OAK would consider lowering the 8% hurdle rate of return (before earning incentive fees) because interest rates are so low.  Marks said that it is a fair intellectual argument to say that that should be lower, but he doesn't want to go to the investor and say they are lowering the hurdle rate due to lower interest rates when he still thinks they can earn 10% going forward.

Marks did say that their funds have done very well when launched in turbulent times but has also done OK when launched in good times.  I suppose we can point to 2006-2007 launched funds.

But even then, interest rates weren't this low even though credit spreads might have been this low. 

In any case, this is just my own reservation.  OAK believes that there are opportunities and that's why they are raising capital.  They are more concerned with deal flow.  It the deal flow is not there, they can't invest, but they feel there is plenty on the way.

I have to say that investing in a fixed income asset manager during the peaking of the biggest bond bubble of all time, and one that particularly specializes in credit analysis when credit spreads are at ridiculously low levels is a little frightening. 

Of course, OAK is just about the best in the business, but even great equity managers suffer during stock market bear markets.   In a real blowup, OAK would definitely benefit as their pool of potential investments would expand.  But their current funds would take big marks against them, so that's sort of a conundrum with owning OAK today.  It can get bad before it gets really great.

Interesting Nugget From Call
By the way, there was an interesting comment from Marks on the call.  Someone asked him about OAK's underperformance (versus benchmarks) in 2012, as they have underperformed by 50 bps or so.

Marks said that nine or ten years ago, some consultant asked OAK to add up their performance in each quarter the markets (benchmark) went up and do the same for each quarter the market went down.  Marks cautioned that this is out of memory, but he said that OAK's funds underperformed by 55 bps in up markets but outperformed by 600 bps in down markets (annualized).

That's a fascinating piece of information.  This should probably go into every OAK presentation.  (I think Och-Ziff puts a similar thing in their filings; how their funds do well in down markets).

Anyway, let's take a quick look at what this thing is worth.

What's it Worth?
At the end of the day, we can't really predict where the bond market and credit markets will go.  People have been calling the bond market a bubble for a long time.  So the most important thing (as Marks would say), I guess, is to figure out what this thing is worth.  The uncommon sense thing for the thoughtful investor to do would be if the stock is trading substantially below what it's worth, buy it (or hold on to it).  If not, sell or don't buy.  Of course, since OAK is a great organization, it makes sense for long term investors to hold on even if it is fairly valued.

We can look at OAK valuation as the sum of four (or five if you include DoubleLine as a separate piece) parts:  Fee-related earnings stream,  incentive fee stream, balance sheet value (cash, treasuries and investments in funds) and off-balance sheet accrued incentive fees.

Fee-related Earnings
In 2012, Fee-related earnings (which is management fee minus compensation expense and SGA) was $307 million.   It was $315 million in 2011.   Management fee-generating AUM has been stable at $67 billion in 2011 and 2012, so I think this $307 million is an OK number to use to value this stream.

At 10x this, that's $3.1 billion value for this stable stream of income.  With 150 million total units outstanding, that's worth $20.70/share.

Incentive Fee Income
This part gets a little funky because it's very lumpy, so we have to make some assumptions.  I think the funds that OAK offers are designed to earn 10% or more over time.

The incentive fee is 20% of what they earn (once the hurdle as passed), and much of that is paid out as performance bonus to the fund managers (and other employees, hopefully).   Looking at the accrued incentive fees at the end of both 2011 and 2012, it looks like employees get 40% and OAK gets 60% (this varies by fund/strategy so may change over time).

So instead of using actual incentive fees earned over time, I'll assume the funds earn 10% (they earned 15% in 2012 so 2012 earnings are obviously better than they would usually be), they get 20% of that and pay out 40% of that for the bonus pool.

Let's assume incentive fee creating AUM of $34 billion.  It was $34 billion in 2012 and $36 billion in 2011.

So the incentive fee earned in a typical year on $34 billion would be $3.4 billion x 20% = $680 million x 60% (40% to employees) = $408 million.

10x that stream would be $4.1 billion.  With 150 million units outstanding, that's  $27.20/share.

Balance Sheet Value
OAK has cash, investments and funds on it's balance sheet and some debt.  This equity value is largely liquid, financial instruments so should be counted at book (funds are carried at market value).

Total assets at OAK was $2.36 billion and total liabilities were $966 million.  Book value comes to $1.4 billion.   If we use $1.4 billion and add it to the above parts, there will be some double counting involved as some of the assets on the balance sheet is being used to generate the above management fee and incentive fee (think office supplies/equipment etc.). 

So let's deduct the $146 million in "other assets".  I don't know what's in there, but we can be sure that PC's, servers and other office equipment isn't in any of the other balance sheet categories.

That would get book value down to $1.25 billion.  That comes to $8.33/share

Off Balance Sheet Accrued Incentive Fee Value
Due to the way OAK accounts for incentive fees (not booked until realized and paid), there is a lot of value that hasn't gone through the income statement and doesn't show up on the balance sheet (incentive fees only hit the income statement and balance sheet when it is paid out (or when it becomes payable)).

This amount of accrued incentive fees held at the fund level is $1.3 billion at the end of 2012.  This comes to $8.52/share.   (If the funds were liquidated today, this is the amount that would be payable to OAK as incentive fees (this is net of what gets paid out as performance bonus too))

Add it Up
So if you add it all up, you get:

                                                   Value of per unit
Fee-related earnings:                      $20.70
Incentive fee:                                  $27.20
Book value:                                       $8.33
Accrued incentive fee:                      $8.52
Total:                                              $64.75

OK, so then there is another piece to this puzzle, and that's OAK's 20% stake in DoubleLine which is on the balance sheet at $29 million. That comes to less than $0.20/share, but it's grossly undervalued there.  

As I said in a previous post, I figured DoubleLine is worth somewhere between 1% and 2% of AUM.  DoubleLine now has more than $50 billion in AUM (versus I think $28 billion at the time of OAK's S-1 filing).   So the value of DoubleLine would be $500 million - $1 billion.  20% of that would be $100 million - $200 million.  That's far higher than the $29 million balance sheet value.

It's already on the books at $29 million, so the incremental value per unit would be $71 million - $171 million.  On a per unit basis that comes to $0.47 - $1.14/unit.

Now, that's not a whole lot given the $50-51 stock price and $64.75/unit fair value.

But Wait!
In the earnings release, DoubleLine's results is included in investment income.  I assume that is a cash dividend distribution to OAK from DoubleLine (I think someone confirmed that on the conference call).   That amount was $22.7 million for 2012.

But on the conference call, OAK said that the DoubleLine stake created distributable earnings of $34 million and that they feel although this goes through the investment income line, it is actually more like fee-related income.  If that is the case, let's put a 10x multiple on that and it comes to $340 million.

That comes to $2.27/unit.  That's far higher than the valuation we would get from a 1%-2% AUM valuation.  Excluding the $29 million already on the balance sheet, that's an additional $2.00/unit in value you can add to the above $64.75/unit  sum of the parts value for OAK.

So the total, total would come to $66.75/unit.

With the stock trading at $50.74/unit right now, that's a 24% discount to what it's worth.

So OAK still looks cheap despite a nice runup.  I don't know the details of the DoubleLine earnings, so I don't know what can be 'normalized' and what's due to a good market last year.  But it seems like using 2012 figures leads to a far higher valuation for DoubleLine than a 1-2% AUM valuation.  I'm still on the fence on that one, but it's certainly possible that DoubleLine can be worth more than 1-2% AUM if they offer more funds with higher fees.   But again, I just don't know the details.

OAK is a solid shop run by solid people and it is definitely one that you can own and be comfortable with over the long term.  I would not worry about management, corporate governance, risk management and things like that.

But what I do worry about is the current state of the fixed income markets and the sub-6% high yield rates.  It just sounds insane to me that junk yields less than 6%.  I don't know how anyone can generate high returns going forward in this kind of market without going further out on the risk curve (and that often doesn't end too well).

I thought initially that OAK would be a great holding in front of a European collapse or something like that; they would raise funds and go over there and pick up the pieces.  But it sort of looks like that might not happen (due to intervention by the ECB etc.).

But seeing how they are doing so well and making so much money in this almost maniacal bull market in credit, I fear what would happen on a hiccup.

I don't worry about OAK over the long term, of course.  But I can't help but imagine that returns on capital raised today will be far lower than any of their funds in the past, and this may not bode well over the short-medium term.

I know, I'm a long term investor and I shouldn't think of things like that; I should just think about the long term.

But there is a part of me that feels like I'm looking at a private equity manager in 2006-2007 when looking at a fixed income manager today.   

Anyway, that's just a quick look and thoughts on OAK today.  I may have more to say or corrections after seeing the 10-k (or more immediate corrections which would be pointed out in comments below).

I still own OAK, but would look to lighten up on further gains.  I wouldn't mind owning a smaller stake as a 'permanent' holding, but wouldn't overweight it too much in my active account.

It's a conundrum for me;  I love the company, management etc., but I don't love the sector at all right now; too much love there... 


  1. I share your concern about high yield spreads, although I think there are two salient points about OAK. OAK will always be about high yield, but is more than high yield ... consider the positive staements about commercial real estate investing Marks stated in the conference call. OAK is increasingly branching out (pun intended) into real estate funds, strategic credit, etc. Secondly, there is a "yin-yang" balance between good markets to raise funds (high yield stressed) and good markets to create incentive income (high yield spreads narrow). You need both to feed OAK's income over time.

    1. Yes, I appreciate that and Marks did mention that there is a time to cash out and nice prices (and a time to be investing).

      You need both, but this current cycle to me seems much more intense than the typical cycle. It really does sort of feel like 1993 or 1997 when the convergence trade was all the rage.

      With treasuries so low, the asymmetry in terms of potential price movement (yield go down more, yield goes up) seems so extreme now.

      But anyway, OAK is fine over the long term and you have to see through to the other side of the valley, even if the downturn didn't start yet. But still...

    2. Oh, and yes, OAK is diversifying into other areas other than distressed debt. Plus they have a stake in DoubleLine which is more mainstream fixed income funds.

      Even still, it sort of feels like a lot of yield-seeking capital is moving into those areas too.

      Thanks for posting.

  2. Not that I have any special insight into OAK's capital planning, but I'll throw out there that what may be the important distinction (mentioned in your post) is that this is a raise... and this doesn't necessarily flow immediately into investments.

    If you believe that the credit market is overheated (and given the fact that Burlington Coat Factory just got a holdco PIK dividend deal done, I think that's probably a relatively defendable position to take) then now MIGHT be the time to raise money to invest at some point later this year or early next year when there is a lot of debt on sale at distressed prices.

    1. Hi,

      Yes, Marks did say that they won't start a fund until they start to see flow. But he also did say that he isn't going to time the market or wait for a buyer's market. If there is flow, capital will be put to work even in the current market.

      And yes, now is probably a good time to raise capital; you raise it when you can. But I don't know that the distressed prices will come right away, and once a fund is raised, as Marks said, he isn't going to wait for a buyer's market so...

      Anyway, I don't usually pay attention to these macro or cycical issues as I like to buy stuff that look good over time on a normalized basis, but sometimes things do seem to go to extremes and when they do so, even if I don't 'time' anything, I would like to try to avoid too much exposure.

  3. Oops, I meant Marks said he won't start investing a fund (where capital has already been raised) until he starts to see flow, but won't wait for a buyer's market etc...

  4. Three thoughts KK --

    1. Accrued incentive fee = I ran into this when I was trying to value FIG, which is also very Credit/HY-heavy investing (going forward anyways -- the PE funds went ballz deep into Real Estate, Financials and Transportation equities at the peak of the 2005-2007 cycle and hence won't meet the hurdle, so I'd expect a lot of that AUM to be essentially in "run-off mode," for lack of a better term). They cite the huge "embedded but unrealized incentive income" in the Credit portfolio, but -- and this is the important part -- FIG has stated they will be *holding to maturity* and will *NOT* contemplate selling the loans. Why is this important? It's because much of these "embedded incentive fee" gains are mark-to-market & mark-to-model gains on their >10% loans which were bought or originated at par and have henceforth seen appreciation due to declining interest rates over the last 2-3 years. In other words -- shareholders will NEVER see these gains on loans because FIG plans to hold them to maturity. So if you believe rates will normalize over the next 7 years (a rough approximation for the avg. tenor of their loans), these embedded incentive income gains will not materialize. I don't know if the same is true for OAK, but I suspect so.

    2. Incentive Fee stream valuation = the "correct" P/E multiple to the incentive fee income stream for Alternative Asset Managers has been a real bone of contention if you read any of the Wall Street analyst reports. If I've learned anything, it's that the P/E multiple is simply a hyper beta, pro-cyclical number that can range from 3x to 15x depending on animal spirits. For example, not 12 months ago, FIG was trading at ~$2.70/sh and the analysts were talking about the "right" P/E multiple on incentive income being 4x -- now they're talking about 12x!

    Instead of trying to play pin-the-tail-on-the-donkey and slap a multiple on it, I just did a relatively simple DCF -- assume the AUM generates 10-15% returns, multiply that by 20% for the "2 and 20" arrangement with LP's, multiply by 40% [FIG's founders are much greedier than OAK's :)], and you've got a $ incentive fee stream. Then I assume it has perpetual growth of 3% (in-line with global nominal GDP growth) and use a 20% discount rate. A 20% discount rate works out to be a ~6x P/E multiple so you can argue it, but I don't know how much different these loans are than subprime mortgage residuals :). Reasonable minds can of course disagree, hence why FIG is trading at ~$6.50/sh today and I think fair value is $4.50-5.00/sh :)

    3. What's in OAK's Portfolio These Days -- you're a lot closer to OAK I am, but I know they have a bunch of Restructured Equities in it from the 2009-2012 restructurings they did. Aleris and Tribune immediately come to mind, and I know there are many many more. So perhaps you're not really investing in a "Credit / HY manager" right now anyways (to say nothing of the other new businesses you already alluded to).


    1. Hi,

      Thanks for the detailed comments! That is very interesting about the accrued incentive fee for FIG. I have not heard about that for OAK, but that may be so. I don't know. That would make a good question on the next conference call, I suppose.

      As for the incentive fee stream valuation, yes, I can see how we can argue about multiples. But for me, the assumed returns that the funds will earn over time is the real question. If you can feel comfortable, for example, that OAK can do 10% over time, then a similar formula to yours and a 10x multiple is fine with me. But to be more conservative, you might want to use a lower return (but OAK doesn't get paid under 8% return). That's where I would make the adjustment. But anyway, there are many ways to skin the cat.

      I even used another method; just assume that OAK 'owns' 12% of the incentive fee earning AUM as they would get 20% x 60% (40% to employees) of what they make. This, of course, assumes that the funds earn over the hurdle rate every year. Plus they don't have to pay for the losses (except for high watermark).

      As for what's in the portfolio, I actually don't know too much about it. I don't follow this area too closely so people in the distressed area including yourself would know more about that than me.

      In any case, these things have so many moving parts and there are many ways to look at it and we all have to come up with ways we can get comfortable. I tend to be comfortable with Howard Marks and what he says; I don't think he would highlight the accrued incentive fees, for example, if he knew that they weren't actually ever going to be realized.

      Of course, I may be wrong on that, but that's not the way I see him.

      As for FIG, I'm not too sure. I do think they are decent, competent people, but overall to date, I have not been particularly impressed with them (to the same extent as OAK).

      Anyway, thanks for posting!

  5. That question on the call from someone about the 8% preferred rate must not realize that is industry standard for PE.

    Don't be so myopic as to only view credit from US perspective -- Europe & Asia at very different points in cycle vs. US.

    FIG incentive fee analysis from other commenter clueless about credit investing -- HY in a PE structure is not that rate sensitive. These are longer lock up vehicles not daily NAV -- takes awhile for the value to be realized in a distressed case.

    Don't understand how you can capitalize incentive fees and then add in the accrued total & not consider that double counting.

    Absolutely believe as a public company they are more willing to raise capital then in past -- but that said recent number was $300 bil distressed in US -- just 3% of US corp credit but still big number.

    Full disclosure i own OAK

    1. Hi, good point about the questioner on the call. But it is understandable as OAK is mostly credit while PE funds are equity. With rates so low, it is understandable that someone might think 8% hurdle rate is too high.

      I agree on myopia of U.S. perspective. Yes, things are at different cycles around the world. The U.S. and Europe alone shows very different phases of the cycle. But my concern is that the groping for yield seems to be a global problem. Interest rates are low around the world.

      As for double counting of incentive fees, yes, I thought of that but I don't think it's double counting. I may be wrong, but my thinking is that the accrued incentive fees that didn't hit the income statement and balance sheet isn't included anywhere in the valuation because it's not on the balance sheet. For example, if it was paid out at the end of the year, the cash balance on the balance sheet would be that much higher (and would show up in the valuation).

      As for the normalized incentive fees capitalized, that is for incentive fees that is expected to be earned going forward.

      Having said all of that, if there is any double counting involved at all, it would be that if the incentive fees accrued were realized and paid out at the end of last year, then the incentive fee earning AUM would go down by that amount. But that would be $1.2 billion on an incentive earning AUM of $30+billion... AUM would probably go up or down by that much on market volatility, fund inflows/outflows etc... so it's small enough to be noise.

      But yes, technically, if one wants to include $1.2 billion fund level accrued incentive fees in the valuation, one must take that out of the incentive fee earning AUM to get the normalized figure. But as I said, in this case, $30 billion +/- is not going to move the valuation needle too much.

      Does this make sense? I may be thinking of it wrong, but that's the way I look at it.

      Thanks for reading posting.

    2. Actually, I'm not even sure about the AUM; does the incentive fee earning AUM include accrued incentive fees or is it net of that? I don't know off hand. If it's not, then there is no double counting. If it is in there, gross, then the normalized incentive fee figure should use the incentive fee generating AUM - $1.2 billion. But again, it's not going to make a big difference either way.

  6. "Preferred Return is Industry Standard"

    Yep, correct, at least going forward now that KKR no longer has it (I can't speak to smaller mid-market shops, etc.).

    "Don't be so myopic as to only view credit from US perspective -- Europe & Asia at very different points in cycle vs. US."

    Yep, I hear / agree with you.

    "Don't understand how you can capitalize incentive fees and then add in the accrued total & not consider that double counting."

    It's a stock (accrued) vs. a flow (incentive fees). If you have a Company with $10/sh of excess cash on it's B/S, and The Company earns a $1 in Normalized FCF which you value (i.e. your word "capitalize") at 10x, you get a valuation of $10 + ($1 x 10) = $20/sh.

    "FIG incentive fee analysis from other commenter clueless about credit investing -- HY in a PE structure is not that rate sensitive. These are longer lock up vehicles not daily NAV -- takes awhile for the value to be realized in a distressed case."

    Haha... OK, look, I understand there's a difference between how the economics actually flow-through the structure vs. how these GP's have to report on a GAAP basis.

    I am NOT saying a credit investor like FIG/OAK (or BDCs for that matter) is not going to securitize their loans or otherwise do whole loan sales -- I AM saying that Management touting their stock having all this "embedded unrealized incentive income" on a GAAP basis *IS* deceptive because you're holding the PV of your fixed rate loans on your balance sheet at today's low discount rates (which are unrealizable).

    Go back and read the Examiner's report for New Century before you nail yourself to the cross of book values :)

    As for your comment "HY in a PE structure is not that rate sensitive. These are longer lock up vehicles not daily NAV -- takes awhile for the value to be realized in a distressed case" -- how do you think they come up with GAAP / Fair Value estimates for these Level 3 Assets? Throwing darts at a dartboard? They use discount rates that are impacted by market rates.

    You may work in the industry, but read an SEC filing on one of these GPs before opining please.

  7. Agree that embedded incentive fees that have not been locked in can easily go poof -- see FIG reports in 2007 & after for proof.

    Agree HY investments will have benefited from drop in spreads/rates. I was thinking more in terms of the improvements in credit quality that can occur at a distressed credit -- that is company fundamental related. To be honest not familiar with precise mandates of FIG credit funds.

    Stock vs flow fees. Sure I can see that except in this case the accrued fees are what will flow into that capitalized stream -- just saying to not double count you have to assume they can earn carry each yr and maintain that balance too -- that is subtle difference vs. Cash/cash flow.

    One more point ---- seems to me annual fee earnings-- deserve higher multiple -- especially related to longer lock up money --vs say a MF firm that can see outflows.

    Incentive fee earnings deserve lower multiple for the greater volatility.


  8. To further point on credit valuations -- returns -- was your point relative to HF's or PE funds -- liquid credits or complex structures; proprietary originated credit vs. Secondary purchases -- again difference in return drivers.

    Forgot about 8% issue -- big difference in long lock up distressed and high yield. Return comparison to current issue HY <5% is not right comparison -- not the opportunity set for these kind of funds.

    Good debate thanks


  9. I agree with the above posts that state that the multiple on incentive income should be lower. Having done some work myself on this (helping a friend value offered equity in a HF employment contract) I arrived at similar conclusions that 'correct' multiple is somewhere in the 3 to 5 range. Using 5x you get to a 51.15 value and roughly where stock is trading now. Now does that make this stock a poor investment here? I wouldn't say so, certainly they have very impressive management (I am a big Marks fan), and unparalleled track record. However, I think when one looks at this company one has to take into account a wider range of outcomes.

    There are three bigger picture things to worry about; 1)overheated HY with all-time low all-in yields 2) absolute size of the HF and 3) How the increasing leverage in the mkt effects AUM in a downturn. I think the issue with this stock is that the pro-cyclicality can affect the stock more to downside than upside at this pt in mtk and at this level of AUM. For example, I don't think its hard to see a scenario where OAK loses 10%, causing AUM to drop 20% (as investors given leverage in system sell what they can ie. good funds like OAK) and I think in that scenario the market punishes both the average fee and incentive income and then applies lower multiples, especially in a year where incentive income is 0. So keeping all your assumptions static and decreasing AUM by 20% and applying 3x multiple to incentive income implies downside of 39.75. Keep in mind that Dan Loeb's AUM dropped 60% after Lehman to keep in mind how volatile AUM can be for even the greats.

    So my view is just that your upside only comes from status quo mkts and your upside/downside is skewed negatively. Its also one of those investments where if you don't buy and world is great rest of your portfolio did well so not missing out too much, but will likely trade at a higher sensitivity on way down. I think much better to sell here and buy if/when a correction happens and mkts punishes this co and we get a chance to own this great management a lot cheaper.

    Good luck and keep up the good work!


    1. Hi,
      Thanks for the thoughtful reply! I actually do agree with you on most points. The risk/return may not be too favorable at this point for OAK, especially at this point in the cycle. If Howard Marks was an equity investor, I would bet he would agree. He says that although we can't time the markets or predict the macro, we should be aware of where we are in the 'cycle', and it's very clear that we are in the final stages of a credit/interest rate up-cycle.

      As for the multiple for the incentive fee, that is very reasonable to use a lower multiple. One reason why I like to post the way I do is that people can just look at what I'm doing and make their own adjustments to something they are comfortable with. I like when people do that too so I can come up with my own valuation.

      My take on the incentive fee is that I look at it more like a call option instead of a volatile, unpredictable stream of income. So to 'stabilize' what looks like a lumpy stream, I just make a simple assumption.

      If you get 20% incentive fees and 50% of that gets paid out in bonuses, that means OAK gets 10% of what they earn on AUM (after hurdle, of course). So to me, that's sort of like owning 10% of the AUM outright. But it is actually even better than that because you don't own any of the downside. So it's like owning 10% of the AUM, but with an at-the-money put option on it.

      This doesn't take into account everything, but just as a simple illustration, you can see how I am not too uncomfortable with a 10x incentive fee multiple.

      If the fund earns 10%, incentive fee is 20% and 50% goes to employees, that comes to 1% of AUM. 10x that figure is 10%. So the incentive fee is worth, at my 10x multiple, 10% of AUM, which is the same as what I said above; having a right to incentive fees is like owning 10% of the AUM outright. (again, this is not exactly the case as there is a hurdle).

      The rest of the stuff, I totally agree with you. These businesses can be very volatile due to the unpredictability of performance and AUM over time. Is AUM going to trend up over time? Down? It's so hard to say.

      And as I said, one thing that impressed me about OAK was their sort of counter-cyclicality (raise more funds in bad times, less in good times), which it seems they might have abandoned due to pressures of being listed. If I had to bet, I would bet funds raised there today will have much, much lower returns than any fund they have raised in the past (and yes, part of that is where we are in the cycle, and part of it is their higher AUM).

      Anyway, thanks for the great discussion.

  10. In your incentive fee calculation, aren't you forgetting the hurdle? If they have a 8% hurdle and you're assuming 10% return, shouldn't the calculation be:

    (10%-8%)=2%....$34B x 2% = $680M x 20% (incentive fee) =$136M x 60% (40% to employees) = $81.6M.

    Capitalize 10x for a value of $816M over 150M unit = $5.44 ......not $27.2? All else equal, this brings your estimate of fair value to $45...

    1. Hi,

      I haven't actually seen an Oaktree fee structure in detail, but a preferred rate usually just means that the advisor won't start accruing incentive fees until the investor has earned 8% on their investment. After that, there is a catch-up provision where the advisor collects a high percentage of the gains until it comes to 20% of the profit and any gains beyond that is shared 80% / 20%.

      I don't know the exact structure of OAK's fees.

      But even with this catch-up provision, my incentive fee estimate might overvalue OAK because even if OAK averaged 10% return in the funds, they won't get paid incentives on years their returns are below 8%. So in that sense, my estimate would be too high.

      In any case, with junk yields at sub-6%, I don't know how OAK will generate any incentive income in the short term...

    2. Just a quick test shows this to be correct. In 2012, the funds earned 15% across the board, Marks said. There was about $34 billion in incentive fee generation AUM at 2012-end. 15% return would have been $5.1 billion, and the incentive fees generated in 2012 was $912 million, so that's close to 20%. AUM has fluctuated through the year so it's not going to be exact anyway.

      But it's close to enough to show that in good years, OAK will earn 20% of the gains, not 20% of the gains minus 8%.

      Thanks for posting.

  11. Gotcha. Thanks for the clarification and please keep up the good blog - very interesting to read.

  12. Hello and thank you for the great series of articles.

    It greatly helped me in understanding Oaktree.

    I am trying to understand the tax structure for this company.
    It seems that for fee related earnings they pay about 27% tax (page 84 in the 10-K).

    In the consolidated statement, the Income Tax quoted does not make much sense (less than 1%).
    The ANI income tax is about

    As far as I understand, because OAK is defined as a "Publicly Traded Partnerships" there is special tax treatment.
    Can you please help?

    Many thanks,

    1. Hi,

      Thanks for reading. The consolidated figures is tricky because included in there are items from the funds. GAAP requires consolidation of b/s and i/s items for some funds they have ownership in.

      Also, the Class A unitholders own 20% or so (forget exact figure) of all of Oaktree. What's not theres' is deducted under minority interest (OCGH noncontrolling interest) or some such line item but the tax only applies to the 20%.

      Thanks for reading!


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