About a year ago, I mused over Oaktree Capital's
Fast-forward to one year later and would-be investors in Oaktree, one of the world's premier distressed debt managers, seem to agree. The company's IPO was received with decided ambivalence, and the share price has since stagnated. With the benefit of more than a year's removal, I'll admit it: I was wrong. Oaktree shares represent a compelling value.
Today, investors can put money alongside one of the most successful money managers of our time at a share price that presumes one of the following: 15 years of outperformance will cease, Oaktree's substantial balance sheet assets are worthless, or its assets under management are in terminal decline. Investors gain exposure to an asset class that's typically off-limits to Joe Investor, neatly packaged in a business with substantial and recurring cash flow generation and a nicely countercyclical bent.
I like those odds, and that's why I'm buying a stake worth 3.5% of my real money portfolio's capital.
The tree's roots
In my years of investing, I've recognized two common features among successful asset managers: a well-grounded, thoroughly battle-tested investment process, which corresponds to successful long-term results; and strong relationships with clients, which culminates in an effective and scalable distribution platform. On these points, Oaktree succeeds.
At the heart of Oaktree's approach is a willingness to question conventional wisdom, take a contrarian view, and a rigorous emphasis on preservation of capital. Characteristically, Oaktree's investments focus on areas where mispricings frequently manifest: distressed debt, control investing, real estate, and other debt securities. As the public-facing manifestation of the Oaktree credo, Marks' memos to clients have garnered a cult following among value investors for his incisive conclusions, wry witticisms, and uncommon sense. Don't take my word. In the leaflet to Marks' book, The Most Important Thing, Berkshire Hathaway
Over the investment firm's almost 25-year record at Oaktree and Marks' former employer, TCW, Oaktree's distressed funds have averaged 23% annualized returns, and its assets under management have swelled to roughly $79 billion, more than doubling in the past five years. It's built a massive network of client relationships, with 78% of clients invested in multiple fund offerings, and a scalable, efficient fundraising platform. A testament to its success, and its clients' satisfaction, comes in this stat: Approximately 70% of Oaktree's management fee-generating revenue derives from assets committed for 10- to 11-year periods, resulting in stable and recurring cash flow.
Despite its record of growth, and the company's typically conservative posture to new fund offerings, the growth opportunity remains large: Despite seemingly ubiquitous status of Blackstone
So, why cheap?
One might ask -- why and how is Oaktree cheap, and how is that apt to change? Read on, dear Fool.
- Are insiders selling? Whenever a company goes public, the first question I ask is, "Why?" If recent share performance is indicative, investors might rightfully be wondering whether they're contributing to Oaktree execs' payday. To be sure, that's not totally true: Marks did sell a small chunk of his holdings, but he continues to own more than 14% of Oaktree. Likewise, for employee-owners of the company, the IPO provides a more liquid medium for eventually turning those Oaktree shares into money, should they choose. To my eye, that's hardly a cash-out.
Complex financials: I won't delve into the numbing details. The short and simple: As a consequence of its operating structure, Oaktree is subject to a series of complex accounting treatments, which on a quick glance, can obfuscate its cash generation. In addition, the company's had large non-cash compensation expenses associated with vesting of equity awards to employees, which gave the appearance that Oaktree's been unprofitable for the past five years. That's not true, and they shouldn't recur. Beneath it all, there's a veritable cash-generating machine, and a fairly easy to understand business.
Among those superficially complex financials, a cadre of valuable balance sheet assets and one off-balance sheet asset also reside. As presented, investors might miss or misunderstand them. Among them: Oaktree's investments in its funds, accrued incentive income (Oaktree's cut of investment fund profits, which haven't yet been recognized), and its 22% stake in DoubleLine Investments, wunderkind fixed-income investor Jeff Gundlach's baby. Taken together, I estimate they're worth about $17/share, against today's $38 share price.
Looks expensive. Isn't: Part and parcel to Oaktree's recently public status is an adjustment period, not much different than the sort recently married couples endure. They grow to understand each other. Such is the dance between Oaktree and the investing public.
An old investor rule of thumb goes that fair value for an asset manager is 2% of AUM. As Oaktree shares trade hands at 7% of AUM, they appear quite expensive. But for Oaktree, that rule shouldn't apply, as its earnings power is substantially greater than a T. Rowe Price
, for example. For each dollar under management, Oaktree's can earn more: It earns baseline management fees equal to 0.5% to 1.8% of AUM; a cut from some of its funds profits, in most cases 20%, if they returns exceed a hurdle rate (called incentive income); and the company's investments in its funds. (NYSE: TROW)
Concerns over the economy: With Europe sniffling, nagging concerns over the U.S. fiscal state, and emerging markets growth slowing, investors are justifiably concerned. Because distressed debt is Oaktree's forte, its model has a countercyclical quality others do not. It takes profits on successful investments as the market pendulum turns up, and the inevitable market disruptions provide opportunity to invest at attractive terms.
The firm has proven remarkably able to raise money in down markets, drumming up a highly successful $11 billion fund during the credit crisis, and so counterintuitive as it is, a fumbling eurozone could benefit Oaktree shareholders. Because 70% of Oaktree's fee-generating assets are locked up for a 10- to 11-year period and 60% of its capital base invested in senior or secured debt at Dec. 31, 2011, Oaktree is again unique: Its asset base is stickier than most of its peers, cash generation relatively reliable, and its securities offer better downside protection.
- Concerns over carried interest taxation: Well before Mitt Romney stepped into the presidential race, a debate has raged over taxation of carried interest (what Oaktree calls incentive income). In simple terms, for those funds where Oaktree takes its 20% of profits, they're most often taxed at a 15% rate. I won't delve into the politics of the matter, but the debate is this: Some argue carried interest is income, and should be taxed at the usual corporate rate. Whatever happens, the market's already discounted that possibility, and then some. So it's kind of a non-factor.
What's it worth?
To value Oaktree, I've employed a "sum of the parts" model. My conclusion is fairly simple: It's hard to lose too much money from these prices. At today's price, the market's assuming that Oaktree's future fundraising and growth efforts will be mediocre at best, as its AUM will grow just about 3% in perpetuity; its returns will significantly lag historical results, at about 8% per annum; and it won't earn any incentive income again. That's right, never. While that could happen, I don't think it's likely.
- Management fee-generating assets: I've examined a range of possibilities, from relatively weak fundraising and a relative failure to capture its growth prospects, to a European fundraising bonanza and new fund offerings. In these scenarios, AUM from new contributions/fundraising grows 3% on the low end, and 5% on the high. On this basis, I value Oaktree's management fees at $19 to $22.
- Incentive income: As a matter of conservatism, I've assumed a fairly wide band of possible returns and taxes on carried interest ramping up to the full corporate tax rate in 2015, for purposes of calculating incentive income. In the low scenario, Oaktree's returns just meet its hurdle rate, 8% in most cases. In the high, I envision Oaktree making 15% annualized returns, well below those of its distressed funds. In this case, I estimate Oaktree's incentive income streams value between $0 and $22, with my preferred scenario, 13% annualized returns, valuing Oaktree's future carry at $19.
- Investments in funds: I value Oaktree's investments in its funds at face value, net of a 15% discount for taxes, or $7.
- Future returns on investments: Remember those investments in Oaktree's funds? They'll make money. With returns ranging between 8% and 15%, I estimate their value at $4 to $8.
- Accrued carry: To account for the possible variability between expected incentives and actual, I've applied a 15%-30% discount to the stated value of Oaktree's accrued incentives, putting their value at $5 to $6.
- DoubleLine investment: Oaktree owns a 22% stake in famed investor Jeff Gundlach's venture, DoubleLine. The investment's reported at cost on Oaktree's balance sheet: $18 million. With $40 billion under management, I'd wager it's worth more. Last quarter, Oaktree received income of $5 million for its share, a $20 million annual run rate. Assuming assets grow at just a 3% to 5% clip, the investment's worth approximately $1.50 to $3.00 a share.
On this basis, I estimate a range of values between $39 and $65, with my preferred scenario putting the shares' worth at $58. Shares currently trade for just $38.
I envision three key risks to my Oaktree thesis. During the credit crisis, Oaktree raised a lot of money; there's a possibility it will not be able to find sufficient enough investment opportunities to maintain its assets under management. Within that vein, there's the chance that Oaktree's performance will lag historical results. In related matters, the recently passed Dodd-Frank Act will restrict banks' ability to invest in private equity funds, which currently comprise 8% of global private equity investments. Last is a massive economic meltdown, of global proportion, significantly impairing the value of Oaktree's assets, thereby reducing its near-term earnings power.
In the end, I think today's valuation, and the strength of Oaktree's model, offset these risks. But I'll be watching.
Amid a misguided unwillingness to buy what Marks is selling, concerns over the economy and markets' state, an overly discounted possibility of tax reform, and decidedly complex financial statements, investors have unduly discounted a company, and investment opportunity, grounded on terra firma.
I'd wager they've missed the forest for the (oak) trees.