Och-Ziff Capital Management IPO Analysis: Dense Financials, Greedy Shenanigans

Nov.19.07 | About: Och-Ziff Capital (OZM)

On November 7, Bill Simpson wrote an analysis of Och-Ziff Capital Management (NYSE:OZM). In the company's debut November 14, shares fell $1.30, or 3.9 percent, to $30.76 in midday trading, after pricing at $32 per share. The firm had expected the offering of 36 million Class A shares to price between $30 and $33 per share. November 16 the stock closed at $28.

The text of Mr. Simpson's original writeup follows:

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Och-Ziff Capital Management plans on offering 41.4 million shares at a range of $30-$33. In addition OZM is also making a private offering to Dubai International Capital [DIC]. The private offering will constitute an overall 9.9% stake in OZM and the price will be the equivalent of the underwriters' discount pricing of OZM's public offering. Based on all ownership stakes post ipo, DIC will purchase approximately 38.2 million shares at a price of $1.50 below ipo price.

Goldman Sachs and Lehman are leading the deal, thirteen other firms co-managing. Post-ipo, OZM will have a total of 390.4 shares outstanding for a market cap of $12.4 billion on a pricing of $31.50. All ipo proceeds from both offerings will go to insiders. The insiders will reinvest those proceeds (in their own name) back into Och-Ziff funds.

Daniel Och will own 49% of OZM post ipo. Mr. Och will retain voting control via a separate share class. In addition to insiders (OZM principals) receiving all ipo proceeds (approximately $2.2 billion), they also declared a special distribution of $750 million payable to them. This payment was made by laying debt onto the back of the soon to be public OZM.

I'm so weary of these 'business as usual' shenanigans. Apparently it is not enough to be wealthy beyond one's wildest dreams, one also needs to pile debt onto the company just prior to coming public to pay one's self even more money. At some point the market needs to say 'enough' to these greed grabs. Mr. Och will have an equity stake in the public OZM of approximately $6 billion, not counting the approximately $1 billion in cash he'll receive from this offering. Was the extra $750 million (of which Mr. Och stands to receive $350 million) really needed too???

I'm not touching this ipo simply for this reason. I'm tired of these shenanigans. If they're this greedy pre-ipo, how well will they treat their silent partners, those buying their public shares? Also, Mr. Och will receive deferred income distributions totaling an additional $1 billion during a three-year period beginning in 2008.

From the prospectus:

We are a leading international, institutional alternative asset management firm and one of the largest alternative asset managers in the world, with approximately $30.1 billion of assets under management for over 700 fund investors as of September 30, 2007.

OZM, a hedge fund and operation focusing on "risk-adjusted returns", has been in operation 13 years. Risk adjusted returns are based on the income generated from primary investment positions while also being hedged to limit risks from market changes, interest rate fluctuations, currency movements, geopolitical events and other risks. OZM goes out of their way to state they look for long term value and to mitigate risk.

OZM derives revenues from management fees and incentive income. Management fees are based on total assets under management and average 1.50% - 2.50% of assets. Incentive income is realized and unrealized gains generated by the funds that are managed by OZM. Incentive income is typically equal to 20% of the net realized and unrealized profits earned. Pretty standard hedge fund revenue structure. OZM's partners (managing directors) receive nearly all their income payments from participation in the profits of the entire business.

Assets under management have grown impressively. OAM had $11.4 billion under management end of 2004, $15.6 end of 2005, $22.6 end of 2006 and $30.1 billion on 9/30/07.

OZM's flagship global multi-strategy fund is the OZ Master Fund. **Note** - The OZ Master Fund has lagged the S&P 500 in each of the following periods: one year performance 3% behind S&P 500; three year performance 0.6% lower than S&P 500; five year performance 1.6% behind the S&P 500. The OZ Master fund has averaged a 13.9% return over the past five years compared to a 15.5% average annual return for the S&P 500. An S&P 500 ETF held the past five years would have returned more than the OZ Master Fund which takes a % of assets as well as a % of gains annually as revenue.

The OZ Master fund holds approximately 63% of OZM's assets under management.

OZM had a losing quarter overall in their funds for the quarter of 9/30/07. This was the first quarter for OZM to not experience appreciation of assets since Spring of 2003.

Financials

$750 million in debt-post ipo. As noted, all this debt was taken on to pay insiders a 'special dividend.'

OZM intends to pay quarterly dividends. They state, 'Our intention is to distribute to our Class A shareholders on a quarterly basis substantially all of Och-Ziff Capital Management Group LLC’s net after-tax share of Och-Ziff Operating Group annual economic income in excess of amounts determined by us to be necessary or appropriate to provide for the operation and growth.' As OZM does not factor in incentive income until the year end, assuming OZM's funds are net positive annually, the fourth quarter distribution stands to be larger than the other three quarters.

Note - OZM is heavily invested in their own funds. This greatly increases OZM's profit when their funds appreciate as they've done annually the past five. However this also means losses can hit even harder. OZM derives approximately 2/3 of their operating revenues annually from incentive fees. These incentive fees are based on a percentage of annual gains in OZM's funds. OZM's gains from investing in their own funds has equaled 1/2 their operating profit in the past 7 quarters. If OZM had a flat year overall in their funds for 2006 for example, they would have had nearly $1 billion less in inventive fees and funds gains putting them deeply in the red for the year. You do not want to be in OZM if they ever have a bad year. Not only will there be no distributions, the losses per share will be pretty staggering.

**Essentially the public OZM is making a significant bet that OZM's funds can continue to perform well year in and year out. Also OZM's managing directors also appear to have much of their net worth tied up into OZM equity and investments in OZM funds. Everyone involved here is making a big bet OZM continues to perform. Keep in mind, if OZM has a flat year in their funds, dividends and earnings will disappear pretty quickly.

As with Fortress (NYSE:FIG) and Blackstone (NYSE:BX), OZM's financials are intricate and difficult to grasp.

2006 - Total revenues were $972 million. 2/3 of this revenue came from incentive fees, 1/3 from management fees. Compensation and benefits were 50% of revenues. Gains from investments in their own funds added $242 million to the bottom line. Pre-tax, OZM earnings $1.50 per share. If we plugged in taxes, earnings would be approximately $1 per share.

2007 - As OZM does not factor in incentive fee revenues until after the fourth quarter closes, net here is negative through nine months. Note that this is a change from the first nine months of 2006, directly due to a pretty significant bump up in compensations expenses. If we're to factor in incentive fees for the full year 2007, I would imagine revenues will be closer to $1.2 billion. Earnings per share should be in the ballpark of 2006, again due to a sharp increase in compensation expenses. OZM looks as if they'll earn again in the $1-$1.50 ballpark. Note that these numbers are highly fluid and much depends on the amount in incentive fees that OZM books on the close of 12/31/07.

Due to all the accounting changes as well as equity distributions and compensation and benefits, OZM's pre-ipo financials are dense and tricky. Going forward, keep in mind OZM is heavily leveraged in their own funds in the form of actual investments in their funds and the heavy reliance on incentive fees. As long as OZM's funds post solid annual gains, OZM will put on a solid bottom line. If OZM's funds have a hiccup in a given year, OZM can easily slip into the red on the bottom line.

Conclusion - Complex dense financial statements in a deal in which insiders are making out extraordinarily well. What strikes me is that in the one, three and five year periods, OZM's flagship fund has underperformed the S&P 500. Why? Because OZM takes not just 2% of assets under management for fees, but they also grab 20% of the profits annually. Why pay someone this much when your return is lagging the S&P 500? OZM has done well growing assets under management in the hedge fund boom this decade. At $12 billion+ market cap though, there are enough question marks and negative to keep me away in range.