Alternative asset management firms like Oaktree (NYSE:OAK), KKR, and Blackstone (NYSE:BX) are complicated businesses, and individual investors tend to shun their stocks because of it.

In this week's episode of Industry Focus: Financials, host Gaby Lapera is joined by Jordan Wathen to dive into alternative asset management, and what factors individual investors should look at before deciding to buy into one. Find out why these firms' business models are so complicated; what kinds of investors tend to use them to manage their funds; what the best of these firms do differently from the rest; how they are similar to hedge funds -- and how they differ; what their fee structures look like; what investors should watch out for; and more.

A full transcript follows the video.

This video was recorded on April 24, 2017.

Gaby Lapera: Hello, everyone! Welcome to Industry Focus, the podcast that dives into a different sector of the stock market every day. You're listening to the Financials edition, taped on Monday, April 24, 2017. My name is Gaby Lapera, and joining me on Skype is Jordan Wathen, an exotic financials expert. Hey, Jordan! How's it going?

Jordan Wathen: Hi, Gaby! I like the intro: an exotic financials expert.

Lapera: I just realized that sounds way more risque than what I actually meant, which is that you know a lot about weird financial businesses, like businesses that have strange structures, and esoteric ways of making money, which is what today's show is about, which is why I introduced you as an exotic financials expert. [laughs]

Anyway, today, we're going to be talking about alternative asset managers. If you're already lost, that's totally OK. We're going to do our best to explain everything, or at least something. Today's question is actually based on some feedback that we got from a listener at the University of Chicago. I forgot to ask his permission to use his name, so we won't, but thank you so much for the great questions. Good luck with your junior year. That's always a long, hard slog.

This is what the listener had to say: "I wanted to hear your thoughts on investing in alternative asset management firms, i.e. Oaktree, KKR, Blackstone. Many have claimed that these firms are trading at a discount for a number of reasons. Their business models and financial statements are egregiously difficult understand, frustrating many retail and institutional investors. There's a drastic variability in yearly results. And profitability is highly dependent on assets under management." My answer to you is yes, yes, yes, and yes. We'll backtrack first. Alternative asset managers are confusing, so let's start at the beginning. What is an alternative asset manager? Jordan, to you.

Wathen: To put it very simply, an alternative asset manager is an asset manager that manages alternative assets. I guess the more important thing is, what is an alternative asset? The best description is that an alternative asset is something that the average Joe isn't likely to own as part of their portfolio. Think things like private equity or venture capital or distressed debt, for example.

Lapera: It also includes stuff like real estate, if it's not just your house, or certain collectible stuff like artwork, but that tends to be very exotic.

Wathen: Right, I shouldn't forget about artwork. I guess, when you think about alternative assets, there's really two things that sets them apart. The first thing is that they're illiquid: They take time to buy and sell. The strategies that these managers use take time to generate returns. For example, Blackstone might by a private company for one of its funds and then hold that company for seven or 10 years before it sells that company and distributes the profits to its investors. A distressed debt fund might buy debt with the goal of taking control of a company in bankruptcy, which is a long slog, a nasty process, and it takes time to generate returns that way, too. So, these funds typically have a lock-up period in which investors can't access their money for five or even 10 years. And actually, there's been some effort by the Blackstones of the world to extend this lock up period for as long as 15 or 20 years. 

Lapera: That's a long time, especially for your average investor, which kind of brings me to my next point, which is that generally, it's not your average investor who's giving money to these alternative asset managers. It's super-wealthy individuals or families, pension funds, and, am I forgetting someone? I feel like I am.

Wathen: Pension funds, state governments, colleges. The Ivy League schools have $250 billion combined between all of them; they're major investors in this kind of world. The big commonality with all these investors is they're generally tax-free. The managers who manage this money can invest differently because their investors don't care about whether or not the returns are long-term capital gains or short-term capital gains. It really doesn't matter because they're not paying taxes anyway.

Lapera: Yeah. The next question would be, how do they make money? As we've answered, it depends on the asset manager, because they might specialize in different things. For example, Blackstone specializes in private equity, but it also does some real estate and hedge-fund solutions.

Wathen: Right. Blackstone is really known for private equity, but their hedge-fund solutions business has grown really big. To define that, it's basically a fund of funds. Someone comes to Blackstone with $1 billion and they say, "We want to invest in the world's best hedge funds, help us find them," and then they take a small cut for doing that. So there's really a bunch of different ways that they can make money.

And, as we talked about, the big difference with alternative asset managers is the fee structures are different. If we look at the world of mutual funds, a company like T. Rowe Price, which manages billions upon billions of dollars, it manages them in traditional mutual funds, things that you and I might own, not private equity funds or whatever. It earns a simple 1% or 0.8% management fee on the assets it manages, and that's it. Alternative asset managers, on the other hand, their funds are structured so they get a management fee, plus incentive fees when they generate returns in excess of a hurdle rate. The investor might want 8% a year, and beyond that, the fund company, if they generate 10% per year, they'll get 20% of that upside, of the 2% over 8%.

Lapera: Exactly. Listeners, what you might be hearing is, these asset managers make money in two different ways. One is through the fees, which sometimes are dependent on assets under management and a bunch of other things. The other thing that they might make money on is their actual investments. Hopefully, they're investing in such a way that they're actually creating profit. But when you talk about investing in an asset management firm, like I said, you're probably not talking about actually giving your money to the asset management firm; you're talking about buying stock in the asset management firm.

Wathen: Generally, these companies, say, Oaktree Capital Group, for example, they manage something like $100 billion of assets. They also have about $1.5 billion that's invested in their funds. But for the most part, the big earnings driver is the fees they generate on the $100 billion, rather than the $1.5 billion of their own capital that they manage.

Lapera: Yeah, definitely. I think the next question that we want to ask -- to go back to the original question that was asked by the listener -- as you guys have seen, these firms can be very difficult to understand, because they're investing in a type of asset that is not really all that commonplace, so you have to understand a little bit about the assets in order to even decode their balance sheet or income statement. The second part of that question is, there can be drastic variability in yearly results, and that the profitability is highly dependent on assets under management. When you're looking at investing in one of these firms, what are some of the things that you should look for? I think the best way to do this is pick one, since they're all so different from each other, and dig in. We talked about doing Oaktree.

Wathen: Yeah. The important thing that you have to remember when you invest in the asset management company is that it's really only as good as its funds are. An asset manager that runs a bad fund won't be in business very long, especially not charging 1.5% on assets, plus 20% incentive fees. The world doesn't want to invest in an underperforming fund that charges an above-average fee. So, one way to get a really good idea of how a business like Oaktree is performing is to look at the balance sheet. Look at net accrued incentives. This reflects how much Oaktree will receive in incentive income from its funds -- basically, fees that it earns for generating good performance minus any bonus compensation that it owes its employees as a result of those returns. What you'd really like to see is this net incentive income, or this accrued incentive income, increases over the course of time.

Lapera: Is there ever [a case of] "This has increased too much?"

Wathen: No, there's no such thing as that number increasing too much. If anything, that would mark something like a cyclical peak. So, if, let's say tomorrow, the debt markets fall out, Oaktree is going to raise tens of billions of dollars and put it to work almost immediately, and within the next couple years, as the economy recovers, you would see that incentive income come up. Then, over time, as those funds are liquidated, they would pay off their investors, and the money would come back to them for generating those superior returns. If anything, you have ebbs and flows in it, but no, there's no such thing as too much.

Lapera: That's actually a really good point that you just made. It's a very cyclical business, much like the financial markets at large. But the interesting thing about alternative asset managers is that they often tend to do well when the market is doing poorly, because they act as hedge funds.

Wathen: Right. Oaktree has a reputation for being the company that doesn't want to attract assets just to attract assets. If Oaktree gives you a call and says, "We're raising a new distressed debt fund," it's because they see opportunities, or they see a world in which they will have opportunities in the next few years. Because of that, they're one of the few asset managers that even runs $100 billion or more. But, they're part of that select group that can really make a phone call and raise $10 billion overnight. I mean that almost literally, because they earned that credibility with investors, and because their returns have been so good over time.

Lapera: Yeah. I think the other thing to look at when you are investing in alternative asset managers is who the management is, because that can make a huge difference. In Oaktree, it's definitely noticeable.

Wathen: Right. They have this company culture that the investor comes first, and the shareholders will be taken care of before that. Actually, if you look at Oaktree's balance sheet, you'll see it has about $6 a share in net accrued incentives that it's earned from these funds, because it calls money when it actually sees good opportunities, not just because it wants to raise a fund and charge more management fees. It's just not that kind of business.

Lapera: Yeah. And for that, you really have to trust that the management knows what it's doing. If you don't trust the management of an alternative asset manager, don't invest in them. It doesn't matter how lucrative it looks, just don't do it, because you fundamentally disagree with how it's being run.

Wathen: I completely agree with that.

Lapera: We talked a little bit about what alternative asset managers are, how they make money, different revenue streams, things that should look good on their income sheet, income statement, balance sheet, 10-K, 10-Q, financial statements in general. Is there anything you would look at and be like, "This is a huge red flag for an asset manager"?

Wathen: I think this extends across any business, financial or otherwise: Truly great businesses have pricing power. That means they can raise prices, or at least control prices, to some extent. For example, if Warren Buffett tomorrow stepped down from Berkshire Hathaway and said, "I'm going to raise a $5 billion stock fund and become a hedge fund manager again," he would have no problem finding investors at 2% and 20%, the typical fee structure. I bet he would even have a line out the door at 3% and 30%. There's actually a company by the name of Renaissance Technologies, it runs something called The Medallion Fund. It's the most legendary hedge fund of all time: It charges 5% on assets, plus 44% of returns. The fees are ridiculous, but the returns are so good, no one cares. If you earn 20% after fees, you don't care what the fees are, it just doesn't matter. So, while investment fees are generally coming down, good asset managers should be able to hold the line, or at least slow the ...

Lapera: The free fall?

Wathen: ... the trend toward lower fees.

Lapera: Yeah. And part of the reason for that trend toward lower fees is actually in an alternative asset management adjacent field, which is the ETFs and the mutual funds and the index funds. You're seeing fees go down really fast in those areas because of the automatically generated nature of these. Companies like Vanguard are pushing for lower fees, because it doesn't make sense in a lot of cases for an S&P 500 ETF, for example, to have a 1% management fee. That doesn't make sense. You're just taking all the companies that are in the S&P 500 -- you're not guessing or anything -- and putting them into an index fund. So, I think you're seeing this widespread fee lowering. The other thing is the power of information. Now that consumers have the internet, they can just go and see what the fees are on other funds, and be like, "You know, I'm not going to pay 1% when I could pay 0.05% for this other fund."

Wathen: It's the exact same thing that's going on in traditional asset managers. If a mutual fund manager could promise me they were going to beat the S&P 500 by 2% a year, I'd happily pay 1.75% a year in expenses and take the 0.25% extra return. No one is going to complain about that. But if the returns aren't there and you're charging a higher fee, you won't be in business very long. And ETFs, and all these passive funds, for that matter, are really just taking more and more share for that reason.

Lapera: Yeah, which is why I, as we circle back to alternative asset managers, they are able to charge higher fees -- because in theory, they're making more than the return on the S&P 500.

Wathen: Right, they're generating superior returns, and they're also working harder for it. Oaktree, when it takes a distressed debt fund and starts raising money for it and then starts investing in it, they're going to have to go through bankruptcy courts, all this stuff, to take control of these companies. It's a long slog. It takes money and capital and geniuses to figure out these opportunities. So, that's what you're paying for, in theory.

Lapera: Yeah. OK. I think, we set out to cover a bunch of things, and I think we've covered them. Listeners, if I'm wrong, go ahead and write me an email at industryfocus@fool.com, and I'm happy to talk about this again. This is probably a topic that can span multiple episodes, but I promise to give you guys a break in between them. So, for people who don't like alternative asset managers -- I don't even know if you're still listening. If you're not, know you have a choice not to listen to the podcast if it's about something boring. I had someone write to me the other day, and they were like, "Why do you cover such boring things sometimes?" I'm like, "Why do you listen to the podcast if you think it's boring? Just skip that episode, go to the next one!" [laughs]

Wathen: Right. It's hard to make financial stocks truly something that looks great. People aren't drawn to them by nature.

Lapera: Yeah. I mean, I think we're fascinating. [laughs] 

Wathen: Of course! I'm not biased or anything, but I would say so too.

Lapera: OK, so, question for you, Jordan. Would you invest in an alternative asset manager? Would you buy stock?

Wathen: Yes. But that comes with a very big caveat that I wouldn't invest in most of them. One of the problems with financial companies in general -- and this extends from banking to asset management to alternative asset management -- is that so many of them are actually run to maximize compensation for employees, rather than profits for shareholders. The shareholders are at the bottom, taking what's left over after everyone has taken their $2 million bonus. As an exception to that rule, the one that I'm most interested in, and I'm glad we talked about it today, was Oaktree. I generally like it as a business model. It's one of the few financial companies that gets better as the world gets worse, which is a nice diversification thing. Earlier this year, I put together a model for it, and I updated it prior to the show, valuing it in two pieces: the assets it owns and the business as it stands. I value it at about $53 per share, and I think that's kind of conservative. And it's a stock that, if it traded a little bit lower -- I had to make a lot of assumptions to get to that valuation -- but if it traded a little bit lower, I would be interested in it.

Lapera: Yeah. I actually also really like Oaktree, especially because the investor letters that they share are always really interesting; a lot of really interesting investment knowledge in there. I encourage listeners to go ahead and read those, they're a pretty valuable resource. As for me, if I would invest in alternative asset managers -- they're currently not for me right now, mostly because I have no money, so I can't actually invest in anything right now, not until I have a little bit more money. But even if I did have money, I think I'm more interested in other types of stocks right now. But I wouldn't rule it out as a future investment.

Wathen: I think timing is important, too. A company like Blackstone, which makes a lot of money from private equity, its business gets better as the world gets better and the economy improves. This late in an economic cycle, I don't know if you want to hold a cyclical company like that, if you want to be the buyer right now this late. With Oaktree, it's the opposite. They get better as distressed debt opportunities come up. So, that would be a company that would get better as things get worse, so it's maybe more attractive this late in the cycle than something like a private-equity company, for example.

Lapera: Yeah. And I know we're going to get an email now saying, "I thought The Fool said not to time the market." That's true. You shouldn't time the market. But it's one thing to be like, "I'm going to time the market and do all this technical analysis," and it's another thing to be like, "I think this cycle is about probably about here, and reasonably I can assume that this is what the business will do if it goes this way or that." And if you're wrong, you can always just buy, if you really believe in the company. Just buy it. Dollar-cost average it.

Wathen: It's not even really so much timing the market. It's like, if I own Bank of America, I know that when the economy gets worse, when unemployment goes up and GDP drops for a few quarters or a year, their loan performance is going to be bad. It's just going to. They'll have more defaults and more loan losses. Oaktree, for example: It's a company where it's going to make more money as things get worse. That's where it really shines. So it's diversification, if anything. Instead of buying, maybe, banks, I want to own a little bit more of this alternative asset manager.

Lapera: Yeah. So, think about it for you. Think about which one you want to do. Do a lot of research to figure out what the company actually invests in, and if it's a good idea, and what part of the cycle that benefits from, and what the fee structures look like -- basically everything we talked about in this episode, I'm not going to say it all over again because we're running out of time.

As usual, people on the program may have interests in the stocks they talk about, and The Motley Fool may have recommendations for or against, so don't buy or sell stocks based solely on what you hear. Thank you very much for joining us, Jordan!

Wathen: It was fun, Gaby. I always enjoy it!

Lapera: I know. And I always really like it when we do these weird ones, because I know that's right up your weird alley.

Wathen: I get sucked in by complexity. It's a disease, really, but it makes it more fun.

Lapera: I think it's wonderful. Anyway, contact us at industryfocus@fool.com, or by tweeting us @MFIndustryFocus and let us know what you'd like to hear about next. We obviously did the show based on a listener question. We are always open for business on that front. Thank you to Austin Morgan, I hope we didn't render you unconscious with that discussion about alternative asset managers. Austin is today's producer. And thank you to you all for joining us. Everyone, have a great week!

Gaby Lapera has no position in any stocks mentioned. Jordan Wathen has no position in any stocks mentioned. The Motley Fool owns shares of and recommends Berkshire Hathaway (B shares). The Motley Fool recommends Oaktree Capital. The Motley Fool has a disclosure policy.