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Oaktree Capital Group, LLC (NYSE:OAK)

Q1 2014 Earnings Conference Call

May 1, 2014 11:00 ET

Executives

Andrea Williams - Head, Investor Relations

John Frank - Managing Principal

David Kirchheimer - Chief Financial Officer

Analysts

Christian Bolu - Credit Suisse

Brian Bedell - Deutsche Bank

Michael Kim - Sandler O’Neill

Marc Irizarry - Goldman Sachs

Mike Carrier - Bank of America/Merrill Lynch

Chris Harris - Wells Fargo

Ken Worthington - JPMorgan

Operator

Welcome and thank you for joining the Oaktree Capital Group First Quarter 2014 Conference Call. Today’s conference call is being recorded. At this time, all participants are in a listen-only mode, but will be prompted for a question-and-answer session following the prepared remarks.

And now, I would like to introduce Andrea Williams, Oaktree’s Head of Investor Relations who will host today’s conference call. Ms. Williams, you may begin.

Andrea Williams - Head, Investor Relations

Thank you, Elan. Welcome to all of you who have joined us for today’s call to discuss Oaktree’s first quarter 2014 financial results. Our earnings release issued this morning detailing these results may be accessed through the Unitholders section of our website. Our speakers today are Oaktree’s Managing Principal, John Frank; and Chief Financial Officer, David Kirchheimer. We will be happy to take your questions following their prepared remarks.

Before we begin, I want to remind you that our comments today will include forward-looking statements, reflecting our current views with respect to, among other things, our operations and financial performance. Important factors could cause actual results to differ, possibly materially, from those indicated in these statements. Please refer to our SEC filings for a discussion of these factors. We undertake no duty to update or revise any forward-looking statements. I’d also like to remind you that nothing on this call constitutes an offer to sell or a solicitation of an offer to purchase any interest in any Oaktree fund.

During our call today, we will be making reference to certain non-GAAP financial measures, which exclude our consolidated funds. For a reconciliation of each non-GAAP financial measure to its most directly comparable GAAP financial measure, please refer to our earnings press release, which was furnished to the SEC today on Form 8-K, and may be accessed through the Unitholders section of our website at www.oaktreecapital.com.

Additionally, references to amounts per Class A unit are after taxes and other costs borne directly by Oaktree Capital Group. Today, we announced a quarterly distribution of $0.98 per Class A unit payable on May 15 to holders of record as of the close of business on May 12. Finally, we plan to issue our Form 10-Q for the first quarter next week.

With that, I would now like to turn the call over to John Frank.

John Frank - Managing Principal

Thank you, Andrea. Hello, everyone. We are very pleased with the results for the first quarter. Strong investment returns and continued inflows brought newest investment strategies brought both assets under management and management fee generating assets under management to record highs. We raised gross capital of $3 billion in the quarter and $13 billion over the last 12 months.

Over the same period, we continued to capitalize an accommodating capital market, realizing and distributing $11 billion from our closed-end funds. Even with those distributions, our AUM reached $86 billion at quarter end, up 3% in the past three months and 9% from the year ago. Fee-generating AUM grew by roughly the same degree to a record $74 billion. Over the last year, we further demonstrated the long-term power of the business model by continuing to build substantial asset value. Our funds created $352 million in incentives in the first quarter and $1.1 billion over the last 12 months bringing our net accrued incentive balance to $1.2 billion as of quarter end.

Combined, our three sources of income, management fee, incentive income, and investment income produced first quarter adjusted net income of $247 million, or $1.46 per Class A unit and distributable earnings of $233 million or $1.41 per Class A unit, funding the upcoming Class A distribution of $0.98 per unit. This will bring our distributions to unitholders for the trailing four quarters to $4.23 per Class A unit.

Turning to investment performance, most major equity markets saw modest gains in the first quarter of 2014 with the S&P 500 index rising 2%. Credit markets generally rose also as the uneven nature of the economic recovery and the lack of inflationary pressures, which sprained the late 2013 rise in interest rates. High yield bond returned 3% as spreads tightened and the yield on the 10-year treasury sales. Our closed end funds generated a gross return of 5% for the first quarter, bringing the return for the last 12 months to 19% and the gross IRR for all closed end funds since inception to 20%. Distressed debt real estate, our global principal and European principal fund strategies all produced about 5% gross return in quarter one. As of March 31, all 48 of our incentive creating closed end funds more than a year old had positive gross and net IRR since inception and 42 of those funds were at or above the 8% net IRR level, which is generally the return threshold you must see for earnings and allocation.

As of the end of the first quarter, over 90% of our incentive creating AUM was actively creating incentives at the fund level. This ability to create potential incentive income and to realize it in cash as we have done for 17 consecutive years is one of the great strengths of our business. Now, question we get a lot is how can Oaktree be finding great bargains and opportunities for future value creation, particularly in our distressed oriented strategy given the run up in asset prices and low incidence of distress? The answer is that we need to look harder and to be more creative, but that there are always pockets of distress and other opportunities even in the most bullish times.

Recently, we have deployed the most capital and real estate situations still impacted by the global financial crisis in shipping opportunities created by overexpansion, reduced demand, and excessive debt and dispositions of European loan portfolios from capital-constrained European banks and then what we call platform investments, where we are establishing new companies with experienced management team to take advantage of the opportunity to supply capital, the capital-constrained industries. Much of the latter, the platform investment, has taken place in Europe, where some of the most established companies are crippled by excess leverage in a banking crisis that has created dislocations even in healthy industries. More than anything, given our experience and access, we are continuing to find opportunities to deploy capital in areas, where others cannot. Indeed one of the greatest strengths of our approach is our ability to operate across the investment spectrum in multiple-fund strategy. In the real estate area, for instance, we have invested over $8 billion across our closed end funds in the last couple of years, as non-real estate funds have joined our dedicated real estate group and exploring and taking advantage of the opportunity.

Now, allow me to walk you through a few examples of what I am talking about. In the case of student housing, our London-based European Principal Group identified a fragmented market with a supply demand imbalance, coupled with strong projected growth for both UK and international students. Partnering with experienced management, we created this student housing company in 2011. In just a short time, it’s become one of the largest owners and operators of student housing in the United Kingdom. The key to our success has been our ability to take advantage of the dislocation in the financing markets for this type of opportunity and the overleveraging that constrained some of the established players, many of which had overcommitted to development at pre-crisis levels.

At the same time, we benefit from the fact that most investors don’t have the ability to accept these types of off-market opportunities. Today, having partnered with distressed developers, acquired development projects and purchased other building sites, we have invested approximately $325 million of capital from our recent European Principal Funds and created a strong operating platform with 21 locations on a market leading brand identity. A different example involves our distressed debt fund, but also in United Kingdom we are in the process of merging two homebuilders that we acquired in the last year, Countryside and Millgate Developments.

We had a unique opportunity to acquire Countryside, a large scale homebuilding company at a slight premium to the book value of its assets. Our acquisition was from a European bank, but held it as a non-core holding on its balance sheet. Combined, Countryside and Millgate Developments will be the second largest privately held homebuilder in the United Kingdom and it’s focused on a most attractive market for the Southeast part of the country that are poised to benefit disproportionately as lousy market improves.

A third example involves the 60 or so residential and commercial real estate NPO portfolios that our real estate and distressed debt funds have acquired since 2010. This represents more than $10 billion of unpaid principal balance. And we believe that our affiliated special servicers have given us the real advantage in both underwriting and working out the pool. The performance of both our commercial and residential loan pools continues to surpass our expectation. And the pace of resolutions and cash flows related to the pools continues to go well. These are but three examples.

The point is that we are focused on applying our expertise across our platform to take advantage of opportunities that are hard for others to access. We feel we have a particular advantage in Europe, where we believe we have built an industry-leading team and presence over the past 15 years. But while we are deploying capital, we are also busy on the realization in harvesting side. Realization activity in the first quarter was strong within our distressed debt and global and European Principal strategy as evidenced by the $2 billion of distributions that closed in fund investors in the first quarter.

With that, I will turn the call over to David to take us through the financials and then I will return for a review of fundraising and strategic opportunity.

David Kirchheimer - Chief Financial Officer

Thanks, John and hello, everybody. The first quarter featured strong cash earnings and value creation consistent with results over the two years since our IPO. The fact that value creation has kept pace with our high levels of value realization bodes well for future adjusted net income and distributable earnings. Additionally, our record high assets under management and a large portion of our AUM that is currently creating incentives at the fund level laid the groundwork for significant future value creation.

For the first quarter, distributable earnings reached $1.41 per Class A unit, while adjusted net income was $1.46 per unit. The rough similarity of the two income measures speaks to the cash based nature of ANI for which the sole mark-to-market revenue component is investment income as we do not recognize mark-to-market revenue associated with unrealized incentive income.

Economic net income, or ENI, was nearly as high at $1.34 per Class A unit. ENI differs from ANI and that it calculates incentive income on a mark-to-market basis using the funds reported values instead of the more conservative cash like basis utilized for ANI. The mark-to-market elements of ANI and ENI make them serve as potential leading indicators for distributable earnings and therefore equity distribution. In fact, over the past two quarters combined, ENI per Class A unit exceeded both adjusted net income and distributable earnings. Thanks to value creation that exceeded value realized in the form of investment income and accrued incentives.

We view that value creation as restocking the pond for future income generation. The strong levels of value realized in the past two quarters make that achievement especially noteworthy. Moreover, spanning the 2 plus years since we were out of the road for our IPO, our aggregate distributable earnings have been about $11 per Class A unit as compared with the even higher $12 for ANI and the still higher $13 per unit for ENI. Thus even as we have generated healthy distributable earnings and resulting distributions per Class A unit, the new value created the prospect of much more. Specifically, as of March 31, potential future distributable earnings represented by net accrued incentives and unrealized investment income was $10.54 per operating group unit, up about 25% from the comparable amounts at year end 2011 on the eve of those three earnings totals I have just sighted. Additional distributable earnings arise from fee-related earnings, our share of DoubleLine’s income, other income and expenses, and of course future incentives created and investment income.

That said I want to repeat my caution from last quarter regarding the expected timing of future incentive income, which we continue to expect to drop in the near-term from its 2013 level. That drop isn’t initially apparent for the first quarter because of tax related incentive distributions, which accounted for about three quarters of the first quarter’s incentive income. Tax-related distributions are generally paid by liquidating closed end funds that are generating taxable income, but not yet paying incentives. We recognized these distributions as incentive income, because they represent the payment of accrued incentives and are not subject to claw back. The tax-related incentive distributions in this year’s first quarter related to taxable income generated by our funds for 2013. Incentive income from these distributions aggregated $117 million, net of compensation as compared with $59 million in the first quarter of 2013 stemming from tax year 2012. We do not expect any more tax-related incentive income for the remainder of 2014.

As I highlighted in last quarter’s call, the expected near-term decline in incentive income reflects two aspects of our incentive creating funds. First, the shrinking and lumpier nature of incentives from Opps VIIb as that fund progresses through its liquidation period. And second, the fact that the roughly 70% of net accrued incentives not from VIIb are largely from funds that have yet to reach the stage of their distribution waterfall where Oaktree is entitled to an incentive share. Specifically, of the $1.2 billion in net accrued incentives as of March 31, about $450 million represented Opps VIIb and other funds currently paying incentives. That $450 million is down from the year earlier’s comparable figure of $780 million. Thus, looking only at net accrued incentives fund level, over the near-term, this revenue source could be expected to generate lower distributable earnings and adjusted net income in the form of net incentive income that has recently been the case.

With that as a backdrop, let’s look at the current second quarter, which is underway, starting with Opps VIIb. That fund made its last distribution in the gross amount of $300 million in late March, which produced incentive income in the first quarter. No meaningful realizations have occurred or are imminent from its remaining portfolio of about $3 billion. Thus, from where we sit today, it would be safe to assume that Opps VIIb either may not produce incentive income in the second quarter or if it does, that its incentive income would likely be lower than the $31 million net incentive income it produced in the first quarter.

With regard to other closed-end fund, this week, a secondary equity offering of Stock Spirits resulted in the first incentive income payment from European Principle Fund I, coupled with another fund’s small incentive distribution that puts net incentive income so far in the second quarter at about $5 million. That in, investment income proceeds from those two and other known fund distribution and total distributable earnings from net incentive income and investment income proceeds equal an estimated $11 million to-date in the second quarter. While there is an inherent volatility to quarterly incentive income, at Oaktree, just to make it current a 17-year concept. Chief among those factors are sizing funds to the opportunities to have strong investment return and the power of credit.

I would like to focus on just one aspect of the latter of those factors, namely the power of the coupon. The current yield from our portfolios’ extensive credit holding gives our funds a meaningful wakeup on their total returns. How meaningful? Well, over the last 12 months, despite the low yield environment, our consolidated funds credit holdings generated an average current yield of about 6%. Including equities, the total interest and dividend yield on our funds overall portfolio amounted to roughly 4.5%. To put this into perspective, that is more representative of a full market cycle. Over the period, since January 2007, interest and dividend income constituted over $13 billion of the aggregate $29 billion of realized income and net gains from these funds. The power of the coupon serves as the vivid example of what’s prevalent across our platform, namely what’s good for our fund LP’s also is good for Oaktree unitholders.

Another good thing is that satisfied clients drive growth in assets under management. That growth is evident in record AUM of $86 billion, up $7 billion from the year earlier balance despite $11 billion in closed end fund distributions. We have also reached record fee generating AUM of $74 billion, up almost $8 billion over the past year. Strong capital flows and deployment kept incentive creating AUM at around $33 billion. Moreover, $30 billion or 90% of that total is creating incentives at the fund level, up $5 billion from a year earlier and the highest level we have had in almost three years. Since the last time this important metric was above $30 billion, Opps VIIb’s share of the total has fallen by over $9 billion to just 10%. The ability to replace that much incentive creating AUM without organizing a similarly large distressed debt fund is testament to our diversification and growth of the franchise.

Finally, a brief word about our balance sheet. As of the end of the first quarter, we renewed our five-year $750 million bank credit facility comprising a $250 million funded term loan at LIBOR plus 1% and an undrawn $500 million revolving credit facility. Our large net cash balance coupled with flexible access to credit markets supported by our A rated financial position provides us ample liquidity to fund our product development initiatives without impairing equity distributions.

And with that, I am delighted to turn the call back to John for update on fundraising and strategic initiatives.

John Frank - Managing Principal

Thanks, David. We had noted on prior calls, our focus on developing products that can help our clients achieve the roughly 10% net return, with risk under the control. Given our expertise in credit, our historic strength in high yield bond, senior loans, and mezzanine lending and our success with our new enhanced income strategic credit, real estate debt, and European private debt strategies, we think we are uniquely positioned to deliver the investment solutions, so many of our clients require. Our results demonstrate that our efforts are paying off. Strong risk-adjusted investment performance across our platform continued to drive fundraising success in the first quarter. Notably, gross capital raised in the first quarter was $3 billion bringing the total for the last 12 months to $13 billion, including almost $6 billion committed to strategies and products that we have launched within the last three years.

As I mentioned last quarter, all of the new strategies and products that have debuted in that time have exceeded our initial fundraising expectations. Let me touch on the first quarter highlights. First, our open end funds saw net flows of $1.1 billion in the first quarter, driven primarily by our emerging markets equity and senior loan strategies. We view both senior loans and emerging markets debt and equity to be among the most promising growth opportunities we have today. The size of each of the markets that we address in our emerging markets distressed debt strategy, our emerging market equity strategy, and our U.S. and European senior loan strategies are in the multi-trillions, meaning we can grow our strategies for the foreseeable future without worrying about capacity constraints.

Our new emerging market distressed debt strategy, what we call emerging market opportunity raised almost $900 million and was off to a promising start. You have heard me say that we believe this will be a very important strategy for us over time and we look forward to leveraging the talents of our team to address the opportunities in Latin America, Eastern Europe, and Asia. Our strong since inception track record for our long-only emerging markets equity strategy has brought AUM in that strategy to $1.2 billion from $100 million two quarters ago. And we have already received inflows of $1.3 billion in April.

On to senior loans, which we identified as a growth priority a few years ago and in which we have expanded our offerings from un-levered senior loans started in 2008 to our moderately levered enhanced income fund launched in 2012 to more levered CLOs, which we have just begun this year. In the first quarter, we closed a $500 million CLO. And in April, we held our first and only close for our second enhanced income fund, which will total $2.2 billion including leverage.

We have found very strong demand from LPs for this successor fund, which we intentionally restricted to around $2 million of total capital. As all of our recent successful step-out strategies continue to scale, we are also excited about the recent fundraising activity for another new strategy, value equities. We launched our value equity strategy in 2012 using our own capital to see the concentrated portfolio of stress, post reorganization and value equities managed by Patrick McCaney, who joined just a few years ago from Goldman Sachs, where he invested proprietary capital in a similar portfolio.

We opened the strategy to decline capital for the first time in the spring and have already closed on $250 million and anticipate reaching approximately $400 million in capital by next quarter. Given Patrick’s impressive performance thus far, we believe we could have readily raised much more capital, but our goal is to limit initial capital and ensure our successful launch and grow over time.

In terms of our traditional strategies, we have begun fundraising for our newest mezzanine fund and are continuing to raise our newest principal fund. Both of those strategies still have capital to deploy in their existing funds. So, we expect fundraising to continue for some time. As I indicated last quarter, our real estate and distressed debt teams are finding opportunity for the faster cliff than we initially anticipated. Our current real estate fund, ROF VI, as of March 31 was over 75% committed. And Opps IX, our latest distressed debt fund was 60% committed. Thus we anticipate beginning to raise their successor funds later this year.

Overall, we are very pleased with the state of our business. We continue to deliver the superior risk adjusted returns that our clients want and need and we continue to see attractive opportunities to grow our strategies, while remaining true to our mission and culture. We have reached new heights of AUM even as we distributed over $35 billion for our investors over the last three years and we have generated $1.1 billion in potential future incentives over the last 12 months, even as we realized $1 billion in incentive income. No one can predict the future, but we are confident that we are well-positioned whatever may happen in the market.

If the economic environment remains benign, we will continue to develop our new strategies and to reap the benefit of our $33 billion in incentive generating AUM. As things become more negative, we will be well-positioned to raise new funds to take advantage of the opportunities that will arrive. We appreciate your interest and support. We thank you for joining the call.

And now, Luanne, you may open the call to questions.

Question-and-Answer Session

Operator

Thank you. And we are ready to open the lines for questions. (Operator Instructions) Our first question today is from Christian Bolu from Credit Suisse. Christian, your line is open. Please check your mute feature. I apologize – Christian, your line is open.

Christian Bolu - Credit Suisse

Good morning. Sorry about that.

John Frank

It’s okay.

Christian Bolu - Credit Suisse

Just a quick question on the – on your emerging market strategy, you have been pretty opportunistic in terms of your investments in China. Cinda recently made your market equity funds. I am curious to hear your thoughts on where you are most bullish or most bearish in terms of emerging markets and any other thoughts on investments across other emerging markets like Latin America and Africa?

John Frank

Well, Christian, what I would say is that I would rather not comment on particular investments, but what I would say, which I think is most relevant to our unitholders is that we are excited to see the growth, first of our emerging markets equity strategy, where we will have a three-year track record as of I think mid-summer July. We outperformed the index last year by about 400 basis points and we are seeing very strong inflows as I referenced during my remarks. So, we think that we will see last year that, that strategy was just couple of hundred million dollars. It’s already over $2 billion and assuming performance remains, that’s an area that a lot of clients are continuing to reallocate capital to and we think that can be a very important strategy.

Now, shifting from emerging market equity to emerging market debt, there we started a new strategy about a year ago and we think that the market for emerging market debt, which is in excess of a trillion dollars is a strategy, which over time could become almost important to us as our mainstream U.S., European-oriented distressed debt strategy. So, as we think about emerging markets for Oaktree, we are very excited both by the growth in emerging market equities and the potential growth in future for our emerging markets debt strategy.

Christian Bolu - Credit Suisse

Okay, great. Thanks for the color.

John Frank

Thanks, Christian.

Operator

Thank you. Our next question is from Brian Bedell from Deutsche Bank.

Brian Bedell - Deutsche Bank

Hi. Good morning.

John Frank

Good morning.

Brian Bedell - Deutsche Bank

Good morning. John, if you could just comment, I think, last quarter, you talked a little bit about some of the retail opportunities in sub-advisory and then potentially, you’re branching out a little more aggressively and maybe creating your own retail product. You just mentioned obviously, emerging market equity will have a three-year track record this summer, maybe if you can just elaborate a little bit more on the plan there and maybe what type of distribution channels you will be targeting for that?

John Frank

Super. Thanks, Brian. Well, as you know, we have got six or seven sub-advisory arrangements already, where we manage on behalf Vanguard, their convertibles bond we manage on behalf of Russell or High Yield Fund we are managing emerging markets on behalf of Northern Trust and several other entities. So, we have an existing – a fairly robust pool of existing sub-advisory relationships and of course we’re up across several strategies and open the more. In terms of developing distribution, that’s a real focus for us. We have begun the market some of funds through some of the wire houses, high network systems and we will continue to do that. We are very focused on continuing to develop 40 Act funds, not just as a sub-advisor, but for ourselves.

We don’t have anything specific to announce on this call, but what I’d say Brian is I’ve said on the prior calls is we’re putting a lot of time and effort into creating the vehicles and the structures, so that we can make the range of our investment costs – our investment product as much as possible, available not just to the institutional investors, but the bulk of our clients today. But to increasing what today is roughly 13% of our client base, which is so-called retail investors, but being able to expand that, being able to find ways into the defined contribution in marketplace, et cetera. So that’s the focus, but we are on specific products we described today.

Brian Bedell - Deutsche Bank

And then is that more of a second half 2014 type of development or do you think it’s more of a 2015 – more like 2015?

John Frank

We will do things along that line. In 2014, we have products that we will put out through wire house banks and we’ll continue to distribute some of our regular products like our new principal bond debt and mezzanine fund whatever. Our new real estate fund through some of these intermediary channels, but this is a process. We have a fantastic institutional business. We’re beginning now to focus more on more immediate retail distribution and it’s an important initiative, but it’s not an initiative for the next six months, it’s an initiative for the next five years to ten years.

Brian Bedell - Deutsche Bank

Alright, great. Okay, thanks so much. I will get back in the queue for follow-up.

John Frank

Thanks, Brian.

Operator

Thank you. Our next question is from Michael Kim from Sandler O’Neill.

Michael Kim - Sandler O’Neill

Yes. Good afternoon. So, my question just has to do with sort of the mix continuing to may be skew in favor of strategies that are targeting sort of high-single digit or low-double digit returns like strategic credit or enhanced income or real estate debt. I know those are still relatively small compared to your legacy, distressed principal and real estate equity businesses. But just curious to get your thoughts on the potential impact to carry or maybe more to the point, the management fee versus carry mix, just as this lower fee, sorry not lower fee, lower return products account for of your franchise?

John Frank

Thanks, Michael. I want to turn this over to David in a second for his thought. But the first thing I would point out to you is, we’re looking over short time period. As I think about the business, as David thinks about the business, as Howard and Bruce think about the business when we manage it, we’re thinking in terms of five-year cycles and 10-year cycle. And then inevitably, I understand this process for public company. You folks are looking as in quarter-to-quarter business. We’re very excited about these new strategies. We’re very excited to see their growth. We are nowhere near scale in most of them, but one thing to point out is these new strategies are additive. We are not getting rid of our legacy strategies. We’re going to raise another big step fund from there. We’re going to raise a new real estate fund. So I’ll caution you not extrapolate too much from short time period, but David, do you want to address that?

David Kirchheimer

Sure. Great question, Michael. The significant of the $33 billion of incentive creating AUM and the fact that $30 billion of that $33 billion happens to be generating incentives now from an almost three year high speaks to the fact that we are still doing quite well in terms of strategies that would be expected to have higher returns than these newer strategies. The substantial amount of incentives created that John mentioned in his remarks also shows that while we are very excited about adding these strategies, they target lower returns, that the foundation of strong incentive creating assets remains very deep and as even before the next downturn cycle, where we would expect to have a substantial additional amount of distressed debt and we’ve got a very large runway we believe in real estate, where you could expect that to increase and when you have a moment, Michael, you can look at the fund table back on page 21, you can see what I’m also I guess alluding to in terms of the strong returns of the more recent funds as well. So we view these lower return type strategies as incremental and additive and certainly not displacing the strong foundation of higher return product that our clients also enjoy.

Michael Kim - Sandler O’Neill

Got it.

John Frank

I will just add, Michael, one of the things I pointed out and I think last quarter’s call, some of these new strategies are sort of slightly more evergreen in nature than our typical closed end funds, where we have a limited investment period and then we distribute the capital over a liquidation period. Whereas some of these funds, although they have liquidity and clients can withdraw money, there is no particular obligation for us to return money. And I think that’s been proved to be a very accretive aspect of these new strategies over time, because there is a fair amount of inertia to climb capital.

Michael Kim - Sandler O’Neill

That makes sense. Thanks for taking my question.

John Frank

Sure. Thanks, Michael.

Operator

Thank you. Our next question is from Marc Irizarry from Goldman Sachs.

John Frank

Hey Marc.

Marc Irizarry - Goldman Sachs

Oh, great. Thanks. Hi, everybody. So just along the lines of investing for the business in the future over the long-term, how much is sort of baked in the P&L for new initiatives to expand either into retail or other channels? And then also I guess for you David and then John, if you have a view on this as well, as the business I guess excluding the next big distress raise up and just looking at the open end fund mix growing potentially, how should we think about the few related earnings margin for you guys?

David Kirchheimer

Yes. Good morning, Marc. So first we always invest in personnel and systems in the back office before we launched a new strategy, so to a certain extent there is always something baked into the expense structure, but at the same time we continue to add people in investment systems and so some is baked in and some is going to occur in the future as we grow, continue growing these new strategies. One example I would provide in that vein is merchant market opportunity fund, where we had higher (indiscernible) PM probably a year or little over a year actually before that fund, which as John said we now have $900 million for it, started generating dollar one of management fees. And it wasn’t just truly over, but building out his team and making sure that we have the number of accountants and compliance people and so forth. So, you should expect cost to increase, but some of the costs are already, to use your term are baked in. In terms of the FRE margin, we have talked before about the roughly complementary nature of our income stream at Oaktree. And by that, I mean that as we go through the cycle and specifically the recovery part of the cycle as we have been in for the last four or five years that as the closed end fund liquidate and pay out incentive income, but naturally that puts some downward pressure on their management fees.

Interestingly, I would say is in the, because the development of these new strategies, management fees have pretty much remained where they are at levels with just little bumping around from quarter-to-quarter and fee-generating AUM just reached a record high. And so that’s why that accomplishment is notable. And then as we move through the cycle and start raising larger funds and John mentioned that already far along for example on real estate fund VI and Opps IX that we would expect some of that to benefit management fees along with new product.

The other thing, you are the one market, I think years ago claimed the term shadow AUM and by that for the benefit of others on the call, that refers to AUM that represents committed capital, but isn’t yet generating management fees, because it is in funds that pay fees based on drawn capital as opposed to committed. And that’s become an increasingly meaningful part of our AUM. And I think as of March 31, there were something like $3 billion or more of that so-called shadow AUM. So, that also speaks to the kind of dry powders, I would call it, in terms of future management fee generation.

Operator

Thank you. Our next question is from Mike Carrier from Bank of America/Merrill Lynch.

Mike Carrier - Bank of America/Merrill Lynch

Thanks guys. David, maybe first question, just on the distributable earnings, I hear the comments just on the near term you are just being a little bit more muted in the tax benefit this quarter. I guess when we think about the $400 million – I think it’s like $445 million or so that’s basically like the incentive that’s accrued that can’t actually be paid out now versus that $1.2 billion. I guess when we think about the time horizon, when those funds can start to get that level. Is there any way to kind of map that out or think about that over like an average, given your history and given that the average time of a fund or is it just too difficult because of the nuances across the different products?

David Kirchheimer

Well, I guess this is when two of used phrases come to mind and by the way, good morning, Mike thanks for the question. One is the, story about the six foot man who drowned in a river of average five foot depth and that speaks to broad nature of averages and the second is I’m going to steal one that John usually uses which is our crystal ball no better than anybody else’s. So I will avoid giving any prediction or forecast as to the liquidation phase or realization phase of that $450 million. That’s where the diversification across the funds, which is quite evident in our fund table. The liquidity of the holdings, a lot of the holdings in the older funds are in the more liquid level, on level two, type holdings, so I’m are referring to Opps VIIb and Opps VI, and Opps VII funds like that. That speaks to the ability to monetize those investments.

Conversely, as we’ve said at AGM and as I said in this call with specific regard to Opps VIIb as those funds work their way towards the end of their life, they become more concentrated and thus the distributions are going to be inherently more lumpy. So, it complicates anyone’s ability to forecast for specific fund. For example, Opps VI and Opps VII and for that matter Opps VIIb all have at this point really concentrated portfolio, so that anywhere from 80% to 90% or more of their holdings were in tough end positions. So, it’s going to be episodic. And so unfortunately, thank you for a good answer other than the diversification of our funds.

And also lets’ not forget the Evergreen fund which won’t pay until the fourth quarter, like value-add entities. But over the near-term it’s very difficult and of course our PMs are entirely motivated by what’s best for the client and they’re not going to monetize anything before its time. But the last thing, as I know you fully understand Mike for the benefit of others is that, there is always a silver line rack in this business and the silver lining here is that to the extent that these funds hold on to their investment longer, the odds are, the investment are going to be worth more thus far we’re holding on to them, that will mean greater intent of income to unitholders. And in the meantime, the longer it takes to sell an investment of course the mansion fees are higher, because you’re not selling out the asset. So I would encourage you and others to not just focus on the incentive income because as I know you appreciate that’s just part of the puzzle.

Mike Carrier - Bank of America/Merrill Lynch

Right, okay. And then maybe as a follow-up, John, I think when we will look at the growth that you guys have had in terms of the assets, and whether the old strategies and new strategies, it’s been – I feel like each quarter, you guys kind of exceed the expectations. And I think on one hand, it’s the opportunities that you guys have come up with or with the client in terms of seeing new opportunities, where assets or allocations are going. I guess what I’m trying to understand is when you think about like the cyclical nature of the environment, and so when you look at the credit cycle and you look at where returns can be right now versus the structural growth, whether it’s because of allocations from rates to credit or allocations away from the banks to fund structures. I guess at this point, like what the outlook for both the growth and then also just returns? And I think on the returns, maybe factoring in what David was talking about in terms of the coupon new generation and feel like cross-cycles, where are the lows of the returns versus the highs of returns?

John Frank

So, Mike, obviously, there was a lot of questions, but maybe I can share with you sort of how we think about the business and none of this was going to sound new to you. Our motivation in everything we do is how can we best serve the client and we’re confident that if we serve our clients well, ultimately our business is going to prosper. The other thing that we like to bear in mind is we don’t need to manage all of the money in the world. There is plenty for us to do without trying to occupy the entire investment horizon. So, we have really extraordinary expertise. We’ve got tremendously talented people working at Oaktree, tremendous professionals with great, great expertise, particularly in credit. And so, what we try to do is find areas where we can apply that expertise to generate attractive returns for our clients with limited or risks under control. And that’s what we promised for our investors, that is what we strive everyday to deliver. And the truth is that in any environment, there is going to be plenty of demand for that. And as long as we are – continue to do what I think frankly you alluded to which is we try in everything we do to under-promise and over-deliver. And while we continue to be successful doing that, our business is going to continue to be successful.

At the same time, we do benefit, as you mentioned, from great secular advantages. There isn’t any question as all – everyone on the call know that there are great allocations to alternative, there are investors around the world who are still just beginning to get into alternative, they’re greater allocation, you saw it in this quarter where the S&P returned 2% and our closed-end funds returned 5%. So, you continue to see the advantage of investing in alternatives. So, as long as we continue to do a good job, we’re going to be okay whatever the return environment. And historically, as we said on the call, our closed-end funds inception to-date have returned about 20%. Today, as we raise funds and we give people an idea of what we are expecting to earn, it’s probably less than that. We are not looking to get 20% right now. When we opened our strategic credit account a year ago, we told people we hoped to get 10%. Thus far, we have done a lot better than that. But the key is to continue to find the opportunities and to deliver returns to our clients in a reliable, dependable way with great integrity. And that’s what everybody at Oaktree is committed doing.

Mike Carrier - Bank of America/Merrill Lynch

Okay. Thanks for the color.

John Frank

Thanks Mike.

Operator

Thank you. Our next question is from Chris Harris from Wells Fargo.

Chris Harris - Wells Fargo

Thanks a lot. First thing I would say is you guys are being way too modest. David, I think your crystal ball is a lot better than most people’s crystal ball. But anyway, the questions I want to ask are in and around Fund IX. If we rewind the clock back a little bit, six months ago or maybe a year ago, the fund was delayed and there was some concern or worry about, not having any opportunities or not having enough opportunities. But now it looks like the Fund is really starting to ramp. And so I guess I am just wondering what kind of changed over that timeframe. Are you guys just more broadly comfortable about the environments or have you maybe identified more pockets of kind of interesting investments like some of the ones, John you talked about. And then kind of related to that, I see that looking at the fund table, this fund is already posting a 30% gross return right out of the box, I mean obviously very impressive. So how are you guys able to achieve such a strong number so early?

John Frank

So, you addressed that to Dave, but I am going to take it anyway. It sort of goes back to what I have said in the last answer, which is we try to under-promise and over-deliver, and Bruce Karsh, Pedro Urquidi, Raj Shourie, Bob O’Leary, the four co-portfolio managers of Oppx IX were very concerned about delivering terrific returns for our clients. They were reluctant initially to turn on the peak lock, because they weren’t confident as to how fast they could invest this on. But as I alluded to in my remarks, there is not a lot of distress in the world, but there are opportunities if you are creative, if you are smart, if you have got a big team on the ground across the United States and Europe as we do, and those folks plus the rest of the people who work with them in London and the United States and elsewhere have been able to find opportunities in real estate, working with our real estate group in shipping as we have talked about, in certainly in the dispositions of loans from the European banks, NPL pools, et cetera. So, they have been able to invest as we said at a greater clip than we anticipated. And I don’t think it’s so much that anything change. It’s just that we didn’t want to go full speed until we knew we could do a good job. So those guys proceeded with great discipline, but we’re effective at finding ways to deploy capital as you say. Thus far the returns have been very, very good. And we’re very excited about where we are and about the fact that we’ll be able to raise another fund sooner than we probably anticipated initially.

Chris Harris - Wells Fargo

Great. Thanks.

John Frank

Thanks, Chris.

Operator

Thank you. Our next question is from Ken Worthington from JPMorgan.

Ken Worthington - JPMorgan

Hi, good morning. There has been a number of comments about the current nature of the credit markets and outside of realizations, I guess, number one is are the steps that you are taking to react to the frothiness there? And then two, I assume if the credit markets start to show some cracks, it will be very positive for fundraising. How much would you expect to raise opportunistically if the credit market had a correction here? And I know you have got potential for maybe an Opps IXb, but what else is obvious there?

John Frank

Hey, Dan. You are right. We have commented and other people have commented on some of the frothiness. And as you know, there is elements that’s not consistent, but certainly there is a lot of capital out there chasing opportunities and that’s exactly – some of the lending standards, some of ratios confidence, etcetera. You ask how will we react with that? Well, the first thing we do is investing. All of our investment professionals, the thing they are most worried about is don’t lose money. And so in our senior loan strategy, we are buying something like one out of every formed new issue that comes out. I don’t know the statistic with respect to our high yield group, but I suspect it’s about the same.

So, we are being careful about what we buy, as we always are. And certainly the folks who manage our closed-end strategy similarly are very, very concerned as to the downside, because that’s in our DNA, that’s how we go about investing. So, the main way we respond to the environment is as Howard would say if he were here, I’m confident what he’d say. It’s important we always sort of know where we are in the cycle. And although we can never tell the future, you can have a fair idea of where you are on a cycle. And we have to calculate our response to that. And obviously on the selling side, it’s been a very good time to sell and realize assets and of course we’ve taken advantage of that.

In terms of the future and if we see signal to the downturn and if things develop such that we think we can raise our new distressed funds, et cetera. How big can those be, as you know we never like to target sizes and we never like to make predictions, but I would say this, we will be creative and we will be aggressive if we think an opportunity is coming about raising enough capital to take advantage of that. So we were very creative prior to the last crisis in raising the smaller Fund VII and a larger standby Fund VIIb. And I certainly don’t want to predict what we will do the next fund? But I would predict we will be creative and aggressive.

David Kirchheimer

Well, I was just going to add, Ken, that in the meantime, in a much, much smaller fashion, the frothiness that you described was, I think, also one of the reasons why we were excited about raising this emerging market opportunity fund because the frothiness certainly seems to have occurred outside the U.S. as well. Well, go ahead, sorry.

Ken Worthington - JPMorgan

Yes. You kind of mentioned like you want to be aware of where you are in the cycle. How does that change behavior? Like I assume it impacts like you are always cautious about what you are buying and protecting the downside, but you are always protecting on the downside is the nature of what you are buying or is there hedging going on? I assume it like varies from product to product, but...

John Frank

Ken, I guess I would say this sort of more generically in response to your question that you have a period like you did and I am going to use extreme examples, but if you have a period like you did following Lehman, where nobody in the world wants to buy anything and everybody in the world wants to sell what they have. Obviously you still have to be aware of where you’re, but you can be a little more – you have a lot of opportunity across the spectra and you can be very, very active.

On the other hand, if you have an environment closer to what we have today, where you have a lot of capital, people are not terribly concerned about risk. And so people are more bullish on their buying. It’s the old Warren Buffet thought about the less careful other people are, the more careful you need to be. Well, if you are in an environment, where most people are not being terribly careful, you need to be very careful. And that’s more the period we are in now. And in contrast, the periods like post-Lehman, I don’t recall (indiscernible), but I think we are investing $250 million a week at some point or even more, yes.

David Kirchheimer

One other example, John, I would just add to that just a little more granular, again this is an opportunity for us to mention a strategy, I don’t think we have yet done, which is mezzanine. So, as leverage multiples have crept up, they are more circumspect about making their investment. So as an example, Ken, what they look for is increased equity cushion, which they are finding by the way in many areas. So, that helps compensate, but they are as John said, cautioned as we are in all strategies. But you’re still able to make investment.

Ken Worthington - JPMorgan

Okay, great. Thank you.

John Frank

Thanks, Ken.

Operator

Thank you. Our next question is from Brian Bedell from Deutsche Bank.

Brian Bedell - Deutsche Bank

Hi, thanks for taking my follow-up. John, you mentioned the platform investment and maybe if you would elaborate a little bit more about the potential scale of the opportunity. I know it’s a gigantic market, so there is no capacity constraint, but maybe if you can elaborate until the next, I don’t know, 6 months, 12 months to 18 months pay book build up in that ability in Europe and hence which way the (indiscernible) that in?

John Frank

So, where we are doing it primarily, not exclusively, but primarily is in our European Principal Fund, which is our newest one, which was a – somebody will help me here, it’s in the fund table to how big it was, but it’s roughly 50% investment now, I think. And their focus, the focus of the European Principal team, which is headed by Caleb Kramer, is very much, not exclusively, but very much on the platform type developments across a range of industries. And the reason Caleb and his team are so focused on these platform investments is, as I said in my prepared remarks, he thinks he’s got a big advantage there and an opportunity to deploy capital in various industries where the established players are often capital constrained or have limited access to new liquidity, both because of their own financial position and the sort of withdrawal, if you will, of the European banks and a lot of their lending activity, so that he can team with experienced managers in industries where they can create new players unshackled by legacy problems and exploit the opportunities that are presently in the marketplace, and that we can do it without a lot of competition from other folks in the marketplace who have got a lot of capital to deploy, who may not be quite as price or value conscious as we are, and so who in an open auction we don’t like bidding against because they will outbid us. But in these sort of opportunities which require a lot of one-on-one negotiation, require a lot of boots on the ground, require a lot of experience and expertise, they really can’t compete. So, I expect that we will see a significant amount of deployment of the capital from the European principal group into these sorts of opportunities. At the same time, it’s not, it isn’t unique to that strategy, our real estate folks do some of that, our distressed debt folks definitely do some of that as well.

David Kirchheimer

And in fact, Brian, you are relatively new to Oaktree, but that technology, that approach of platform investing has been protected that Oaktree over more than two decades, aircraft leasing for example is a platform type investment that we have done probably three or four times time. Basically, every time there is a downturn, we felt a void of capital. We capitalized on our tremendous network of management talent, couple that with our internal portfolio enhancement groups and are able to acquire as this create a company and then ultimately write back the cycle and realize it at a very nice profit for fund investors. So, these platform type investments have become a hallmark at Oaktree and we are very excited about how they are – the opportunity is even bigger today than ever before.

Brian Bedell - Deutsche Bank

Yes. And that sort of what’s my question, because if you look at the few funds that you just mentioned at European Principal free and let’s say if you look at growth opportunities fixed, together those funds are something like 50% drawn on, you can combine them, but still only $3 billion type funds, so it sounds like the opportunity to raise lot more capital in successive funds is pretty robust, near-term?

John Frank

Well, they at a time, Brian, we first want to do a good job of investing the money we have. And then we will worry about investing the money, we don’t have, but certainly with respect to real estate which you alluded to, we are highly, already highly invested in that fund. I mean, the growth of our real estate strategy, I do want to touch on. I remember first doing these calls after we did our IPO couple of years ago and people said, I mean, well, where are you going to see some growth. And one of the things we talk about was real estate. And I just want to point out I think our real estate strategy has grown fourfold over the last X number of years, I don’t know exactly five years or so. And we think it will continue to grow and it deployed capital rapidly and you are right about that, we will raise another, hopefully large real estate funds, fairly soon here.

Brian Bedell - Deutsche Bank

Great. Thank you for taking my follow-up.

Operator

Thank you. Our next question is from Marc Irizarry from Goldman Sachs.

Marc Irizarry - Goldman Sachs

Just – hey guys. Just John, I guess along the lines of the last question. So if you look at the overall I guess both U.S., Europe globally, is the opportunity for you guys more around the – around banks and asset sales or is direct lending a bigger opportunity for you guys in terms of where you are going to put money to work? Where do you think that bigger opportunity is? Is it in sort of the – in the non-core asset sales or direct lending? And then related to that, when you went out to the market and go out to the market to raise funds, you try and size appropriately to that, but where do you think there was more money chasing, chasing too few returns out of those two buckets?

John Frank

So, I think the answer to you is yes. What I mean by that is there is great opportunity – increasing opportunities we take as some of the European banks get a little healthier, they are doing – they are accelerating the divestiture of the problematic loans. So, certainly there are large loan pools that created good opportunity. At the same time, there is opportunity to do direct lending, certainly in Europe also to some degree in the United States. And we would like to do both. You said, where are the greatest opportunities to put capital to work and where is the most money chasing the opportunities? I am not sure I have perfect knowledge of that, but the common sense tells you that when European loan – when European banks are divesting loan portfolios, they are often doing so in some sort of competitive process. And there are certainly lots of folks who have raised money to pursue that opportunity. So often that’s a competitive process, where people will have more money and lower standards, it can sometimes outbid you. In the direct lending space that tends to be more of a negotiated space, where you need more boots on the ground to do it and so it can sometimes be less competitive. I think there is good opportunity in both spaces and there is good opportunities for Oaktree in those spaces. And we are interested in pursuing them, are doing so and we will continue to do so.

Marc Irizarry - Goldman Sachs

I will agree with that.

John Frank

Thanks, Marc.

Operator

Thank you. And we have no further questions, Ms. William.

Andrea Williams - Head, Investor Relations

Thank you again for joining us for our first quarter 2014 earnings conference call. A replay of this conference call will be available for 30 days on Oaktree’s website in the Unitholders section or by dialing 866-443-6901 in the U.S. or 1-203-369-1120 outside of the U.S. That broadcast will begin approximately one hour from now. Thank you so much.

Operator

Thank you. And this does conclude today’s conference. You may disconnect at this time.

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