Our recent presentation on Oaktree (OAK) has generated significant interest from friends and investors, and so we’d like to address a few follow-up questions we’ve received and add some more color to our original analysis. Because Howard Marks, CFA, is an active member of CFA Institute, I thought it was quite fitting to do so through a conversation with Inside Investing.
CFA Institute: If we strip out 2013 incentive fees from your valuation, the company is now trading at close to intrinsic value. What needs to happen to generate $2.83 per share in incentive income in 2013? Has Oaktree given a sense of where it thinks those returns will come from?
Christopher R. Pavese, CFA: Before we detail our thinking on 2013 specifically, let’s step back and review the “value of carry,” to which the market assigns little value today. Marks recently elaborated on this subject at a Goldman Sachs Financial Services conference. His main points:
- Oaktree Capital Group LLC (NYSE:OAK) recognizes and receives carry only after LPs (limited partners) have received their capital back and met their preferred return. This point is called “crossover.” To date, $2.1 billion of gross carry ($1.3 billion net of compensation expense) has already been accrued on OAK’s books (roughly $8.50 per share). Note that we discount this figure in our valuation to account for the uncertainty of future conditions, liquidity, etc., but one could argue that it is a fairly firm value (more below).
- Roughly $5.00 per share of accrued carry is from Opps VIIb alone. As of 30 September 2012, OAK would have had to distribute approximately $12.3 billion to reach crossover. Last month, it reached $11.1 billion distributed, leaving $1.2 billion plus subsequent preferred return accruals to be distributed to reach crossover. We expect OAK to reach crossover on Opps VIIb in 2013, likely representing a significant jump in distributions to investors and a catalyst for shares. Importantly, much of the taxable income related to this carry has already been recognized. The best shelter for increasing tax rates is for them to have been prepaid.
Marks went on to explain the high-quality nature of OAK’s carry, which is one of many reasons we prefer the stock to its more cyclical asset management peers:
- OAK’s risk of clawback is negligible because the company recognizes and receives carry only after LPs have received their capital plus a preferred return. This is a much more conservative position than that of most private equity peers, providing us with much greater comfort in our estimates of value.
- Because the assets that underlie the accumulated carry are more likely to be debt than equity, they are less subject to a drastic loss of value. Furthermore, OAK’s debt is more likely to be senior than subordinated, and so we believe our capital is well protected from difficult markets.
- Impressively, OAK did not have negative incentive income even in 2008. To date, all of its 47 closed-end funds that were more than a year old had positive gross IRRs (internal rates of return) since inception and 35 were above the 8% net preferred return hurdle required to earn carry. OAK has earned incentive income every year for the last 15 years and every quarter for the last 35 quarters.
That being said, investors should understand that we are living in a different world today from the one when those returns were generated. With interest rates pegged at the zero bound, it will certainly be more challenging for OAK to deliver the 19% annual return it has historically averaged on closed-end funds. Clearly, Marks recognizes this challenge because he has told clients that OAK is targeting the lowest returns it has ever sought. “In the distressed strategies, like distressed debt and real estate, we’re aiming to make 15% gross. The irony is of course that today 15% sounds like some Herculean task. It’s the lowest yield we’ve ever targeted.” We think they are in the ballpark. OAK’s latest flagship fund, which began investing in 2009, had a 13.6% gross IRR through last quarter, whereas predecessors of the pool have returned as much as 35%, per the firm’s filings.
Still, using even more conservative return assumptions than OAK’s already reduced hurdles, we have projected our incentive numbers forward for the next several years. For example, we assume just a 10.5% return on closed-end funds, and so anything closer to “normal” would represent a significant upside to our valuation. Although we based our estimate of intrinsic value on 2013 numbers for purposes of this presentation, we typically look ahead three to five years when thinking about this type of investment. So, our 2013 numbers are really just a function of longer-term expectations and not necessarily indicative of specific point estimates. In any given year, incentive income will vary considerably with market conditions, but we believe it is more reliable than the market gives it credit, for reasons discussed earlier. What’s important here is to take a longer-term perspective in valuing the smoothed future incentive income. And although we may be living in a “different world” with regard to the current interest rate environment, in many ways the more things change, the more they stay the same. OAK is a natural beneficiary of macroeconomic uncertainty and market price volatility, two factors that should remain a tailwind for the firm’s strategies and present plenty of opportunities to generate future returns.
How should we approach valuing this company when one of its large assets (its stake in DoubleLine) is difficult to assess. How do you think about that asset as part of the overall picture? Is the company easier to value without it?
One of the intriguing aspects of our investment in OAK is that you don’t have to pin a precise value on the DoubleLine stake to achieve a comfortable margin of safety, although the investment certainly has greater value than most recognize. In fact, most of the Street models we’ve seen largely ignore the stake, and so this is something of a “hidden” asset. We approach the current investment in DoubleLine in two ways:
- The first is to value the firm on the basis of a percentage of AUM (assets under management) because fixed-income firms have traditionally exchanged hands for anywhere between 1% and 2% of assets. DoubleLine recently surpassed $50 billion, and Jeff Gundlach, DoubleLine’s founder, has commented that $100 billion is the likely cap. The firm is growing at a tremendous rate, with great success in its market segments. If we value OAK’s stake at 1% to 2% of its potential AUM, it is worth $1.50 to $3.00 per share — in effect, a nice cushion for us and a great investment for OAK, but not something that will determine the ultimate success of our investment in OAK, even on the high side of our estimates.
- Another method is simply to value OAK’s earnings from its investment in DoubleLine. In the last nine months, OAK has attributed investment income of $16.3 million to DoubleLine. This amount represents growth from a base of $629,000 in the previous nine months. Given this growth trajectory, we think annualizing the most recent quarterly earnings is a better reflection of value than the nine-month figure. OAK generated income of $7.2 million from the DoubleLine stake in the third quarter. Annualizing this figure brings us to $28.8 million of pretax earnings. Putting a 10×–15× multiple on this estimate results in a value of roughly $2 to $3 per share, in line with our AUM-based appraisal.
Can you unpack your thinking process in looking at OAK versus other large asset managers with more diversified product bases?
One of my favorite quotes from Seth Klarman’s Margin of Safety is, “Diversification for its own sake is not sensible.” In his 2006 Letter to Investors (emphasis added), Klarman expanded on this notion:
The idea that you should own a little bit of everything is a concept rooted in market efficiency. If the markets are efficient, you cannot outperform anyway, so by owning a bit of everything in just the right proportions, you stand to reduce portfolio volatility, while at least avoiding underperformance. This is the best that you can hope to do in an efficient market. For any fundamental-based investor, this is complete hogwash. Investment comes in the following varieties: undervalued, fairly valued, and overvalued. Price is everything, and every investment is undervalued at one price, fairly valued at a higher price, and overvalued at some still higher price. You buy the first, avoid the second, and sell the third. Having a goal of diversification, rather than owning value, causes investors to take their eye off the ball. It is a refuge of investment wimps, owning a little bit of everything to avoid being wrong, but thereby ensuring never being really right either.
Warren Buffett shared a similar philosophy in his 1965 Letter