Almost two years ago, I purchased shares of Oaktree Capital (NYSE:OAK), one of the world's foremost distressed- and alternative-asset managers, on the heels of its IPO for my Real Money Portfolio—recognizing an under-appreciated premier franchise, superior economic model, world class fundraising capacities, and a huge opportunity.
Shares have since returned 51% including distributions, handily outperforming the S&P, as the market took a shine to Oaktree. This as prelude, it might seem odd that in a market devoid of values, Oaktree shares languish near a 52-week low today.
The parallels to two years past are eeriliy similar: Then, as now, investors question shares' valuation following a secondary offering, the sustainability of its cash generation, and in a general sense, misunderstand the fundamentals of its profit-generating model. Enterprising investors can purchase one of the world's savviest investment managers with still-large growth prospects and a wonderfully cash-generative model at 12 times my estimate of its normalized free cash flow—a strikingly cheap price for a spectacular business.
I'm a buying a position equal to 1.5% of my Real Money Portfolio's capital.
Oaktree: A Retrospective
To understand why Oaktree's became cheap requires a brief examination of its business model, recent history, and sources of profit. Co-founded by value investor extraordinaire and purveyor of plainspoken, incisive investment wisdom, Howard Marks, the company made its name in distressed debt. Today, the firm manages $83 billion, but Oaktree's no one-trick pony.
Over the years, it's expanded its mandate to real estate, real estate debt, control investing (taking ownership of assets or companies), corporate debt, and equities. Though they straddle asset classes, they're unified by common thematic elements: Oaktree invests, and aggressively, when market dislocations manifest, limits its forays to areas requiring specialized knowledge, and keeps a rigorous value focus. Its investment funds take one of three forms:
- Closed-end funds are finite life, typically 10 to 11 years, and subject to lock-ups, meaning clients cannot withdraw funds. These funds are opportunistic in nature, and carry hedge fund-like fee structures—about a 1.5% management fee, and provided management attains an 8% annualized return, Oaktree is entitled to 20% of fund profits. On account of their structure, these funds are able to invest in illiquid assets, bankruptcies, or physical assets, where traditional fund vehicles are constrained. In this regard, and for its credit specialization, Oaktree is distinct from its asset manager peers—Legg Mason (NYSE:LM), Franklin Resources (NYSE:BEN), and BlackRock (NYSE:BLK). These funds represent 54.4% of assets under management (AUM).
- Open-ended funds more closely resemble typical mutual funds, but as its closed-end, are restricted to institutional and accredited investors. These funds take a fixed management fee (as a percentage of assets), and investors are free to withdraw funds as they please. For this reason, certain investments suitable for closed-end funds are off limits to open-end funds. Open-ended funds comprise 40.5% of AUM.
- Evergreen funds split the difference between closed-end and open-ended. Many of them are entitled to performance fees, and they're subject to lock-up. But as open-ended funds, investors can contribute capital on an ongoing basis. Evergreen funds make up 5.1% of AUM.
Though a portion of Oaktree's cash generation and profits are relatively reliable, because a chunk of its AUM are locked-up and earning management fees, there's still cyclicality. That owes to Oaktree's model: When and if markets are subject to stress, it typically raises huge chunks of cash for its closed-end funds. It did just that during the credit crisis, raising $18 billion for two distressed funds. As markets improve, it harvests its investments, returns capital to investors, and in doing so, typically earns incentive income (20% of fund profits, subject to achieving an 8% annualized return). For this reason, incentive income is lumpy, and these years typically represent near-term cyclical peaks. It also highlights a unique counter-cyclical element of Oaktree's model: Downturns are a friend of Oaktree investors, enabling the firm to raise large closed-end funds and prime the pump for future profits.
That brings us to today. Oaktree's had a spectacular couple of years, paying $8 worth of dividends from its credit crisis bounty. Unfortunately, or perhaps fortunately, most of these funds' are nearly liquidated, and with that, the associated incentive income's likely to slow. Oaktree is a manager with a nose for value, and markets having run more than 100% in the past five years—pickings are comparatively slim. Oaktree's not raising $18 billion funds right now, and with its '08-09 windfall past, its profits and 7.8% distribution are likely to decline in the near-term. The market's gotten hip to that. That management recently sold shares in a secondary offering (a large chunk of bonus compensation is Oaktree shares), only reinforced its dull view of Oaktree's near-term.
That categorization takes short-sighted view of a very fundamental aspect of Oaktree's model and history: Cycles happen. Today's frenzied, ebullient activity—of opportunistic debt raises, highly levered private equity deal, and lucky go-go M&A—give way to tomorrow's opportunities. Across its history, Oaktree has systematically exploited markets' tendency to extremes, and whether tomorrow or years hence, will again. And I think its market opportunity is huge.
Where many interpret Oaktree's bailiwick as only distressed debt, its markets are in fact much larger, as noted above. To wit: The company's raised $10 billion or more for the past seven years, has proven adept at expanding its platform, and managed to grow AUM at an 11.5% annualized rate for 10 years running. And even though Oaktree's liquidated the vast majority of its '08-09 vintage funds, it's still managed to maintain AUM and accrued incentive income (incentive income that's likely, but not yet recognized) thresholds. That gets to the larger point: AUM will wax and wane in the short-term, and profits will fluctuate with incentive income, but the long run remains bright.
Consider its core markets: The total value of U.S. commercial real estate is $11.5 trillion, high-yield debt issues totaled $812 billion in 2012, $737 billion of high-yield debt and bank facilities will mature between 2014 and 2018, and $1.3 trillion worth of commercial real estate loans will mature from 2014 to 2017. Two growth avenues stick out. Emerging market corporate bond issuance is still comparatively small, at just $300 billion last year—a market that will grow, and afford opportunities for Oaktree. With banks shedding complex credit assets, as mandated under Basel III and Dodd Frank, and European banks retrench from lending markets, Oaktree's credit expertise uniquely suits it to serve a burgeoning secular trend.
That's a long way of saying that, with $83 billion under management, Oaktree might just be scratching the surface.
What's it worth?
By my math, the market's priced shares for the following outcome: That AUM will decline to 2007 thresholds—a period of great complacency as viewed against market history, and little opportunity for managers of Oaktree's orientation—and scarcely recover, and fund returns will slip to 11% annualized. For context, its closed-end funds have produced 19.9% annualized returns, as of last year end. As investors fret over Oaktree's secondary offering, a little perspective again helps: Oaktree's principals still own a lot of stock. For the reasons above, I don't think Oaktree's market potential is tapped, and certainly, the long-term opportunity set exceeds 2007's offerings.
Don't get me wrong: AUM might decline in coming years. Go-go markets don't breed value investments. For that reason, I've modeled a 20%-25% decline to AUM in coming years, as Oaktree raises smaller funds in response to the market environment. But given a longer-view, I expect that Oaktree will grow AUM at a 4% clip as Oaktree expands its markets, compound 13% annualized returns as the firm, and continue to expand its platform. Coupled to its balance sheet assets—the firm's investments in its own funds (and future income), accrued incentives, its investment in DoubleLine, and net cash—which I value at $28, I peg the shares' worth at $70.
That's why I'm happy to let the market fret over Oaktree's short-term. I'll own it for the long-term.