Oaktree Capital (OAK) is one of the companies in the private equity space I really like (previous update here). Many companies in this space appear deeply undervalued. Drivers of the systemic undervaluation appear to be exclusion within the ETF universe (due to partnership structure), tax complications and unpredictable performance fees.
Actually asset managers as a group look very inexpensive. Both on an absolute basis and historically. The narrative continues to be that ETFs or Exchange Traded Funds are superior to active management. If ETFs will continue to dominate, asset managers may not turn out to have been all that inexpensive but that seems highly unlikely. At some point, an equilibrium between passively managed and actively managed funds will be established.
Finally, the cheapness of asset managers can be explained because we are nearing the end of the cycle and consequently this runaway bull market. Asset managers tend to do very well in bull markets. Asset flows are positive and assets increase in value as well. Of course, this dynamic works against them when the direction of the market is reversed. The market is pricing in some of that cyclicality by assigning low multiples.
The last couple of months have been very informative regarding Oaktree Capital's resilience. Part of the reason I like this investment a lot is because its specialization in distressed debt, track record in distressed and proven ability to raise capital during a downturn. Theoretically, this company is making money for you as we enter a recession or at least a bear market. That's when they are doing the intelligent buying and creating value that will bear out in the future. In the turmoil of Q4 2018, the stock held up really well:
There haven't been any real tests since the firm IPO'ed but this gives us an idea of its staying power. The company also just updated on the quarter and jumped 4% in response (a huge move for Oaktree).
Here are the most important takeaways from their earnings call and implications for the investment case (all emphasis are mine):
Jay Wintrob (CEO):
The market declines in the fourth quarter stood in short contrast to the optimistic market conditions that prevailed over the first three quarters of the year. Against this tale of two markets and fast changing investor sentiment, Oaktree demonstrated solid closed-end fund investment performance of negative 1% for the fourth quarter and positive 9% gross for the full year, further validating our discipline and risk controlled investment approach.
Private equity tends to do really well in downturns because they don't mark-to-market. So don't take this negative 1% too seriously. This absence of volatility is one of the reasons pension funds are attracted to the space. But for the most part, this lack of volatility is all that it is. A lack of measured price action. Economically, the same things are happening under the hood but valuation changes aren't recorded the same way. At the same time, Oaktree's funds likely held up much better than those of its competitors.
Jay Wintrob (CEO)
Consistent with our focus on seeking value, we were able to take advantage of the market declines in the fourth quarter by investing $4 billion from our closed-end funds, shifting our posture from a net seller in the first half of 2018 to a net buyer in the back half of the year. ,Also we feel good about our strong fund raising of $13 billion of gross capital in 2018 and our current balance of $19 billion of dry powder positions us well for any expansion of investment opportunities across our strategies.
Oaktree deployed some capital opportunistically (~3% of AUM) but not that much. The firm has about $120 billion of assets under management. I believe this is only equal to the rate they "need" to deploy on a quarterly basis to remain mostly invested given this level of AUM.
Howard Marks (Co-Chairman)
On the other hand, as you indicate, part of the weakening of the deal structures over the last several years has been the disappearance of covenants. And when there are no covenants, it means everything else being equal that any distressed that does arise defaults I should say, that does arise can just happen later. It can happen for technical reasons, breach of covenant and it can only happen for money reasons.
And so, all things being equal, the defaults will come later than they otherwise would have, but they'll probably be worse because by the time company is default having been able to go on and do business for a long time and breach of covenants, they would tend to dissipate more of their assets. So the rating agencies for example have estimated that recoveries will be considerably less from this round of financing than the historic levels, so many cross currents.
Chairman Marks raises the interesting point, which did not occur to me, that the absence of covenants in the debt that's currently being issued is contributing to a lengthening cycle. Firms can't violate covenants because there are none. That means when they do default, it is with a bang. By that time, there aren't a lot of restructuring options. Marks expects this sets up great opportunities for Oaktree in the next recession.
Valuation Of Oaktree Capital
I left off KKR (KKR) and Apollo Group (APO) because the former takes a different balance sheet approach and Apollo Group obscured the graph because it was trading at super high multiples. Another way to think about Oaktree is like this:
Oaktree trades at about $42 per unit.
The $42 consists of:
$14 worth of investments held.
$5.17 earned but not collected incentive fees per share.
$4.2 DoubleLine value (estimate of the value of a 20% equity stake in a fast-growing fixed income manager)
That means we are only paying about $19 for the operating asset management company.
My favorite way to value asset managers is by percentage of AUM. Oaktree's operating business seems to be valued at only ~3% of AUM. Private equity companies (and I consider the entire space undervalued) are some of the most valuable asset management companies. That's mostly because they:
1. Lock-up capital (about half of Oaktree its AUM is locked up for 10 years)
2. Collect substantial incentive fees
That's why a dollar raised by Oaktree is more valuable than a dollar that is raised by some indexing shop that fails to add value or collect fees on the assets. PE shops tend to be valued between 2%-10% of AUM. There's almost always something very negative going on when they hit the bottom of the range. Oaktree's operating business is awfully deep in the bottom half of the range given this is a quality firm that places tremendous emphasis on risk control.
The entire asset management space is out-of-favor. Private equity is a particularly neglected neighborhood because they don't get indexed, they generate big payouts randomly through incentive fees and they often have a partnership structure that complicates the tax situation. Oaktree is trading near the lower end of the valuation universe of private equity firms while it is a very strong firm that emphasizes risk control and is well positioned to weather the end of the cycle. This is still a great buy.
Check out the Special Situation Investing report if you are interested in uncorrelated returns. We look at special situations like spin-offs, share repurchases, rights offerings, M&A events, etc. But we also have a keen interest in the commodity space. Especially in the current late stages of the economic cycle.
Disclosure: I am/we are long OAK, BX. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.