For most familiar with the investing world, Oaktree is famous for its founder, Howard Marks. He’s a distressed debt pioneer and he, with his partner Bruce Karsch, has led the company through just over three decades of substantial outperformance (over benchmarks and the S&P 500). They’ve long had a philosophy of conservatism and risk control and have operated to the tune of “avoid the losers and the winners will take care of themselves”. They are value investors to the core. For those unaware of Howard’s memo’s, I highly suggest reading them and signing up to receive future notes. He’s also written one of the best books on investing called The Most Important Thing. I highly recommend it.
I’m not posting here just because I admire the firm, but because I think there’s money to be made. Let’s first run through the math and why I’m jotting down these notes then I’ll return to more of what the firm does and it’s opportunities for expansion.
Today, Oaktree is trading at $39.35 with a Market Cap of 6.16B on 156.29M shares outstanding.
Balance Sheet Assets
Book Value of $2.02 Billion or $12.73/share
- Includes: Net Cash of -$100 Million and total investments (Inc. investments in own funds) of $1.7 Billion
Accrued Incentives (earned but unrealized gains – also defined in footnote 5 of page 75) of $920.9M or $5.89/share (or $3.82/share assuming 35% tax rate)
*20% stake in DoubleLine capital: $800m or $5.11/share
Total balance sheet value: $21.65
In 2017, the company had distributable earnings of $716M or $4.16/share for an earnings yield of 11.6% (716/6.16B market cap). That’s just one year and perhaps a year of over-earning, so we ought to look longer-term. To get a sense of their real earning power over time, I’ve included the below charts which show what the business yielded to its owners over the past eight years (note that there’s no credit cycle in those eight years – so it’s likely conservative considering Oaktree historically makes a lot of money when the credit cycle turns from expansion to contraction).
Adjusted Net Income average: $643 million
Economic Net Income average: $648 million
Distributable Earnings average: $634 million
The lowest average of these earning metrics comes to $634 million. That’s equal to $4.05/share.
Let’s revisit the balance sheet: $21.65 in value. Over time, the business seems capable of earning over $4/share per year. Today’s stock price is $39.35. If we take today’s price, less the assets on the balance sheet, we get the actual business being valued at $17.70/share. That business earns $4/share. So effectively, we are paying 4.4x earnings for Oaktree’s operating business. Those earnings primarily come from fee income (which is likely worth at least 15x multiple) and embedded incentives (which are inherently lumpy and unpredictable but are easily worth at least 8x). In simple terms, Oaktree at 39.35 looks too cheap – let alone for a business with a strong history, long-term capital (7-10 year lock on Closed-End Funds), very strong managers, and good alignment of management incentives.
Let me back up here as I can see the pointing fingers and question marks from the sharp-eyed crowd. Some may argue that giving the balance sheet credit and the business credit is double counting. I don’t think it is. The company’s balance sheet investments in their own funds don’t pay management nor incentive fees so there would be no loss to management fee income if the balance sheet was unwound. The balance sheet does produce earnings for the company in that realized gains flow down to distributable earnings as other income. But we are just valuing the balance sheet at book value. Because there are earnings there, we could simply value it at maybe 1.5x book due to a mid-teens ROE and come to a similar (or higher) valuation. Or we could use the book value of the balance sheet then go further to unbundle the thing to value it as I started in the previous paragraph. For example, we could strip out fee-related earnings of maybe $1.50 and assign a 15x multiple ($22.50). We could strip out the incentive income (repeatable, though lumpy and unpredictable), then tax it and come up with something like $2.30 at 8x ($18.40). Add those together, plus balance sheet assets and we’re over $60/share in value.
Perhaps I’m looking through rosy glasses, so let’s view it another way. (Oaktree’s definition of accrued incentives is on pg. 75 footnote 5). If distributable earnings and accrued incentives do have an overlap and counting both is actually double counting, we’ll strip out the accrued incentives from the NAV. And perhaps Oaktree is required by regulators to have some of their own capital at risk in a few of their strategies – so investments in their own funds could not actually be fully unwound. For the thought exercise, we’ll only give 60% credit to the investments in their own funds – effectively saying that $400 million in investments is not worth anything to the owners of the business because it’s required to run the business (like surplus to an insurer). Now we have $3.87/share credit for the investments in their own funds and we’ve removed $5.89/share in accrued incentives from the balance sheet NAV. This takes the balance sheet value down to $13.80 – a large and probably conservative haircut to my more rosy scenario above. This also means that the market is assigning a value to the actual business of $25.55 (today’s share price less $13.80). In other words, the business costs us 6.4x earnings on earnings of $4/share.
Is a best-in-class asset manager worth more? If it’s worth 9x earnings, that’s $36.45. Add the $13.80 in NAV and we’re at $50.25 in value or a 28% upside from today (excluding distributions we may receive in the meantime). I don’t think that’s unreasonable, but reasonable people might use a different multiple.
Oaktree made a fortuitous investment in Jeff Gundlach after he founded DoubleLine Capital in 2009 by buying 20% of the business. Jeff was an Employee of Howard Marks in the pre-Oaktree days. DoubleLine has had tremendous growth and currently, assets under management stand at of over $100 billion with 17% growth in 2017. Oaktree received distributions from DoubleLine in 2017 of $68 million. If the earnings distributed to Oaktree are regular (check) and are growing (check), they are probably worth 15x. That would put Oaktree’s stake is worth some $1.02 Billion. In the balance sheet assets, I assigned $800m in value. This investment is carried on Oaktree’s balance sheet at cost (equity method) of $39M.
When thinking about investing in or with an asset manager, there are a few hierarchies we would do well to prioritize. If the asset manager doesn’t have the first one, run away.
- Does the manager have total integrity?
- Do they have actual deep fluency?
- Is their fee structure fair?
There are a few other questions of benefit such as: Do they operate in an uncrowded investment space? What is their record of historical performance? or Do they have a long runway for growth (young managers)? – all are beneficial to think about. But if there is evidence of a no in the three main categories, the manager or fund is uninvestible. One might be surprised how many asset managers fail this simple test.
Oaktree’s bread and butter is distressed debt. The firm salivates over changes in the credit cycle – they may even pray for distress. The idea in this business is that when good companies end up with a bad balance sheet and capital markets become less friendly, there’s a lot of good opportunities for those with patience, fluency, and mental fortitude. This has never been truer than it is today. With recent defaults bordering on nothing and interest rates near zero, leverage has been hoarded and exploited – junk bond issuance has been very strong and covenant-lite is the standard. US companies are substantially more levered than ever before(excluding financials). These are generally signs of loose credit and loose credit eventually tightens. If interest rates move up when a refinancing wave hits (2020-2022), there will be a lot of trouble. Even without a rise in rates, there is about $430 billion in junk bonds maturing in the next three years (alongside $1.5 trillion of investment-grade). A simple hiccup in our normally cyclical economy will probably freeze capital – and if history rhymes it will ironically freeze the longest and hardest for those that need it the most.
Oaktree’s goal is to opportunistically invest to attain the best risk-adjusted returns. In any given year, they are almost never the top performer in their category, and never the worst. Their consistently good batting average makes them one of the very best over an extended period of time as others reach too far for risk in times of blue skies while others can’t or won’t reach for returns when the clouds roll in. Oaktree generally looks for senior or secured debt of financially distressed businesses with hard asset values, dependable cash flows, and durable business franchises. Sounds good, but that’s what everyone tries to do. Results speak for themselves.
Oaktree has had very strong historical results to back their philosophy and strategy. Closed-End Funds have drawn a total of $78 billion and earned IRR’s of 19%. US and European High Yield Bonds have annualized high single-digit returns (9.4 and 8.1% respectively) since their inceptions in 1986 and 1999. Other satellite and newer strategies have also performed very admirably.
Oaktree’s clientele is diverse and impressive with 75 of the 100 largest US pension funds, 38 US states, 369 universities and foundations, and 16 sovereign wealth funds among corporations, families, insurance companies, etc. A lot of this money is very sticky based on long-term locked commitments and past good experiences (returns) with the firm. I won’t go any further into business operations, as the company’s 10-k and investor presentations are a fine place to find more detailed info.
Within the $100 billion of assets under management at the firm, Oaktree has $20 billion in uncalled capital commitments that are not yet earning management fees nor producing incentive income. Oaktree has raised this money in anticipation of a turn in the credit cycle – i.e. in anticipating that the economy is inherently (and remains still) cyclical. Oaktree wants plenty of capital to deploy when the rougher times manifest themselves. Oaktree will almost surely begin deploying part of this money with a fund called Ops 10b within the next year or so – though based on their past, I doubt they will charge management fees on much of it until they really have put a large slug to work.
With 20% of the firm’s AUM not yet earning anything, this works out to a very large option for today’s purchaser. Essentially, we get the free option of a large portion of their capital beginning to accrue fees.
Real estate is a relatively new area for Oaktree, though it has received a large inflow of client assets since it’s inception in 2008. AUM is at $9 billion, with a 24% CAGR in assets since 2008. Performance has been very strong with losses minimal. Real estate, obviously, has plenty of opportunities worldwide and a long runway.
In February of 2017, Oaktree introduced the Global Credit Fund which is a sampling of 10 different Oaktree credit strategies. It’s a highly diversified fund, overseen by Bruce Karsch and run by his 10 portfolio managers. Inaugural year returns were about 100bps over the benchmark. This fund is somewhat of a sampling of all Oaktree products. AUM has just reached $1 billion.
Many of their other funds have large runways remaining without being dilutive to current returns. Those might include Power Opportunities, Infrastructure, European Principal, and Special Situations. All will have large opportunity to capitalize during the next downturn (whenever it actually comes). Of course, any distressed debt centered strategy will likely have ample opportunities for capital should the US or Europe see a significant hiccup or recession.
I think Oaktree is likely cheap and safe as is. The firm has a solid history, sticky capital, very safe balance sheet, superb management, and hidden assets. Currently, they are a net seller realizing the high prices in today’s market. With new capital, they are playing defense. If we see a turn in the economy or credit markets tighten, and Oaktree is able to capitalize using the discipline they have in their past, it might be very cheap.
As a side note, the last time the company bought back stock was in 2012 at $34/share. If we use AUM as the metric, the shares are cheaper today then they were then. Since 2012 there has been a huge increase in the value of DoubleLine, making the shares almost surely cheaper. Perhaps we might see a buyback…
What’s it worth? I don’t know, but at today’s price we’re probably picking up a dollar for between 65 and 78 cents.
***As is always my disclaimer, do your own work and verify the numbers. This is not investment advice, just general musings***