Och-Ziff: A Hedge Fund With an Upside

Aug.16.11 | About: Och-Ziff Capital (OZM)

Och-Ziff Capital Management Group LLC (NYSE:OZM) is a publicly owned investment manager. The firm provides investment advisory services for its clients. Founded in 1994 by Daniel S. Och, OZM is one of the largest institutional alternative asset managers in the world with approximately $28.4 billion in assets under management as of February 1, 2011.

Share Price: $11
Intrinsic Value: $17
Buy Below: $12
The funds seek to generate consistent, positive, risk-adjusted returns across market cycles with low volatility and low correlation to the equity markets. The company has the unique ability to limit the use of leverage to generate investment performance - and we emphasize preservation of investor capital. OZM serves the investment needs of a diversified institutional investor base, providing asset management services through the funds, which pursue a broad range of global investment opportunities. OZM has built an experienced investment management team around the world. As of December 31, 2010, it had 405 employees worldwide, including 130 investment professionals and 19 partners, working from its headquarters in New York City, and offices in London, Hong Kong, Mumbai and Beijing.
OZM is a strong play in the growing asset management business. It is a lucrative long- term investment based on its high dividend yield and its truly “hedged” nature of around 120%-130% in long positions and 80%-90% short positions. The asset management business comprises broadly two units, traditional asset management such as mutual funds and alternative asset management such as hedge funds and private equity funds. OZM has its presence in both categories through various fund offerings such as OZ Master Fund, OZ Europe Master Fund, OZ Asia Master Fund etc.
In the funds category, the company currently focuses its funds on a multi-strategy approach (Credits, merger arbitrage, derivatives/convertible arbitrage) across multiple geographies. Its presence in the hedge funds category is characterized by its Och-Ziff Hedge Funds that differ from the other funds in terms of the strategy and the asset classes that attract investments. The hedge fund industry has grown from being a $539 billion industry to around 1 trillion over the last 10 years. Although the assets under management (AUM) of $28 billion with OZM might only represent a small proportion within the larger pie, the fragmented nature of the industry means this is a sizable amount. The AUM of OZM has grown from $5 billion to $28 billion over the last 10 years.
OZM revenue is primarily derived from its management fees and incentive income. The management fee is the fee that OZM derives for managing a particular sum of money. This is usually 1.5%-2.5% of the assets management and averages around 1.7%. These are calculated quarterly and paid on a quarterly basis by the clients. Incentive income is usually based on the performance of the funds and is typically equal to 20% of the net realized and unrealized profits attributable to each fund investor. For long-term investors the long-term earning potential of such a structure (attributable to the growing asset management industry and the consistent returns generated by OZM) is more important to concentrate on than current earnings. OZM is mainly assessed by its sales and the AUM, which indicates the investor’s confidence placed on the company. OZM has been continuously adding around $600 million every month this year and as of its June quarter AUM stands at around $30 billion. The sales have been growing strong - hitting around $780 million for the three quarters so far. The company is poised to hit $1 billion in sales in 2011 with EPS of around $1.4. Here it is also important to note that OZM’s sales have also been greatly attributable to its institutional structure and investor friendly nature.
There are indications that there is an increase in demand for transparency about the positions and the various strategies employed. To address this OZM has increased its IR team to satisfy the increased demand placed on OZM by its investors. This is likely to have a very positive impact on its AUM and its revenue.
There can be significant volatility in the earnings of OZM based on its sensitivity toward the performance-based incentive. Considering the unpredictable nature of stock markets, it would be interesting to look at OZM as a market performer and any additional market returns should be treated under alpha generation for the investor. It might be likely that OZM will outperform the markets and this gives a potential upside to the company’s revenue. Considering the recent volatility in stock markets coupled with an increase in cash position by OZM from 0% to 7% recently, the ability of the fund managers at OZM to predict the market cycles seems apparent.
According to an interview by Daniel Och (CEO), management seemed optimistic about the market environment and positive on generating higher alpha for investors. Since returns are an important factor driving the growth of this company along with its attitude to pay most of its income as dividends (dividend yield of around 8-9%), the company is an attractive option for investors. However the global macro risks of a double-dip and the leverage problems in Europe keep opening newer skeletons for investor’s every day. The fact that OZM has been able to identify such risks in advance and provides some confidence for investors.
There was skepticism surrounding the effect of financial services legislation announced in late 2009 on the hedge fund industry. At the end, the legislation turned out to be positive for hedge funds because there were no meaningful changes that would impact the industry or the returns. Under the new legislation the hedge funds investment process seemed to be positive. Deleveraging by banks and brokers has reduced the buying power at competitors in many of the areas Och-Ziff focuses on. Also, in terms of legislation there is also a possibility that that tax rates could move up in the future, and that will have an impact on the company’s bottom-line.
The last few years have witnessed scams in the fund-of-funds category in the wake of the Madoff and Rajarathnam scams. This may have an impact on its fund-of-funds segment growth but there is likely growth in other channels. The growth in AUM could come from direct channels rather than intermediaries. This movement is witnessed by the decline in OZM’s investor base from 40% fund-of-funds to the current value of around 23%.
The recent downturn has proved to be a positive for OZM on the hiring scene. While the size of the firm at around 405 across 5 countries does not give it a large employee base, the economic condition over the last two years has helped bring in some good talent. The company has not seen any major attrition or departure of any of its top management. This suggests a level of commitment by the management. It is also to be noted that some of the lock-ups from the IPO will expire in December 2012, so there may not be many departures before that.
The investment in asset management firms come with a share of risks. To name a few, there may be legislation that may increase the tax rate of Och-Ziff to the traditional C-Corporation rate, which might impact the earnings up to 30%. Given the decline in markets and the fear of a double-dip making rounds in the market, it might be possible that investors would demand lower fees or a higher proportion of profits from investments (reducing OZM’s incentive based earnings). However, in the past management has been very transparent and open about letting investors draw their money during the credit crisis in 2008, which was a fair treatment. Finally, scalability is an important issue in the hedge fund business and it is no different with OZM. It might be difficult for hedge funds to maintain the returns that drove them to this size in the first place. One way to deal this would be to launch newer products to diversify the product portfolio or expand further into newer geographies.
Management & Stewardship
Daniel Och is the founder, Chairman and CEO of the company. Daniel comes with a lot of investment banking experience from Goldman Sachs (NYSE:GS) and his finance degree is from reputed Wharton. There are five more members on the board, all of whom come with vast experience from reputed firms such as Hanover Trust, Hanover Asset Management, Goldman Sachs etc.
The company manages a unique compensation structure for the board whereby the partners only receive dividends paid from the stock they hold and no bonus. However, this may have an impact in moving junior level employees to senior level without affecting the compensation structure. Daniel Och holds around 51% of the Group A shares, 1.2% of the Class A shares and around 75% of Class B shares. The insiders of the company hold around 48% of Class A shares.
Valuation
Due to nature of volatility in the earnings of OZM and a lower predictability in its earnings a relative valuation was performed against a DCF valuation for OZM. The values of OZM against some of its peers are follows, and given the nature of its growth in earnings and sales the stock is targeted to hit $15-$18 based on its earnings or sales multiple.

Note: OZM P/E was calculated after adjusting for the extraordinary expense that the company incurs (reorganization expense) by paying its Pre – IPO partners.


Disclosure: I am long OZM.


Disclaimer: This discussion is for informational purposes and should not be taken as a recommendation to purchase any individual securities. Information within this discussion and investment determination of the author may change due to changes in investment strategy when warranted by changing market conditions, or if a security’s underlying fundamentals or valuation measures change. There is no guarantee that, should market conditions repeat, this security will perform in the same way in the future. There is no guarantee that the opinions expressed herein will be valid beyond the date of this presentation. There can be no assurance that the author will continue to hold this position in companies described herein, and may change any of his position at any time. We use or best efforts to obtain good data in our models, however it can’t be guaranteed that our inputs and data are correct. This is not a recommendation for readers to purchase shares in the above security without consulting your financial professional to discuss your own risk tolerance and objectives.