Howard Marks’ comments from the Oaktree Capital Group fourth quarter earnings call.
Howard Marks – Oaktree Capital Group, LLC – Co-Chairman
Thank you, Andrea, and hello, everyone. As is our practice at year-end I’ll devote most of my remarks to our investing activities and the environment. David will cover financials, followed by Jay Wintrob, who as you know became our first-ever CEO in November of last year.
Last quarter I told you that Jay embodied an ideal combination of fresh thinking and continuity with our culture and values. Since then he’s more than validated our confidence in his leadership potential.
We’ll soon mark the 20th anniversary of Oaktree’s founding and the third anniversary of our IPO. While those are naturally times to reflect on past accomplishments, our focus is on doing even better in the future.
Oaktree was founded on the belief that doing right by clients is the surest path to the Firm’s long-term sustainable growth and prosperity. While I believe that our record over the past two decades demonstrates the soundness of that guiding principle, the challenges and opportunities over the next 20 years demand more.
In Jay, we have the perfect leader to tackle the challenges, capitalize on the opportunities, and pursue even greater growth and prosperity. On Jay’s first day, he sent a note to employees saying, quote: I’m not here to change Oaktree; I’m here to make it better.
I couldn’t have been more thrilled with that message. In just three months, Jay has integrated smoothly into the organization and begun to make his presence felt in many constructive ways, the common denominator of which is engaging employees to the benefit of all Oaktree stakeholders.
We are thrilled to have him working alongside us.
Now on to the main topic. I often say I’m not sure what to root for: bear markets, when our portfolio market values drop but we are able to sow the seeds for future gains; or bull markets, when bargains are hard to find but we harvest earlier investments and produce strong returns for clients and unitholders. The global financial crisis illustrated the former, while the subsequent period through 2013 generally characterized the latter.
2014 defied easy labeling. Equity indices went up, down, or sideways depending on market cap, industry, or geography. Fixed income markets also diverged, with government debt benefiting from continued aggressive monetary policy, while riskier corporate debt suffered from the possibility of increased defaults.
Against this backdrop, it’s not surprising that our performance was also unusually dispersed, with the blended return for our markets and for ourselves well below the recent average. Across our closed-end funds we rebounded slightly from the third quarter’s blended gross return of minus 1% to the fourth quarter’s plus 1%. That brought the full-year gross return for our closed-end funds to 9% in 2014 as compared with 22% in 2013 and a 20% IRR since inception.
Continuing with the theme from early last year, two of the areas where we are busiest investing, real estate and Europe, featured the highest returns. For the fourth quarter, real estate had a gross return of 8%, boosting its full-year return to 28%, while European Principal generated a 5% gross return in the fourth quarter, pushing the full year to 20%.
Distressed debt, while benefiting from cross-holdings with real estate, suffered for a second straight quarter from market price declines in some public equity holdings. Quarterly and annual gross returns for the strategy were negative 3% and positive 1%, respectively.
The relative lack of distressed opportunities over the last few years had caused portfolios to become relatively concentrated. As our funds age, we sell fully valued holdings, further increasing our concentration, and exchange some of the remaining debt-holdings into equity and restructuring.
The greater share of distressed debt portfolios in public and private equity holdings, now close to 60%, has increased the volatility of our quarterly returns.
Recall that the Opportunities Funds sold and distributed $24 billion back to their investors during 2011 to 2013, leaving just $11 billion among funds in their liquidation period as we entered 2014. That cyclically lower level of capital lessened the impact on our funds’ since-inception returns of the quarterly and annual returns that I just described. That since-inception return remains strong at a blended 23% gross.
Over the past two years our closed-end funds have deployed a total of $15 billion, of which about $8 billion went into real estate investments. That real estate deal flow, which is up significantly over the prior two years, is testament to the global platform built by John Brady and his team. Often working in concert with our distressed debt group, they’ve done a terrific job of sourcing and managing a broad range of very attractive investments. Prime among these have been commercial and hospitality properties, as well as nonperforming loan pools bought from eager sellers in the US and Europe.
The fourth quarter featured an excellent example of our resourcefulness and internal synergy in real estate. Back in 2011 the real estate and distressed debt groups collaborated to form a specialty REIT in the middle-market sale leaseback business that they named STORE Capital. STORE stands for Single Tenant Operational Real Estate.
Together with a management team that has worked together to 30 years and that we knew well, they proceeded to acquire a $2.8 billion portfolio of restaurants, health clubs, movie theaters, and supermarkets, to make STORE among the fastest-growing net lease REITs in the United States. After scaling the business and its strong cash flow, STORE executed an IPO in November, which was quite successful. The current price represents a 1.8 times multiple of cost and a 35% gross IRR for our funds.
Stories like this illustrate the successful growth of our real estate effort, which we expect to continue this year with the third new Real Estate Opportunities Fund in just the past four years. That pace is remarkable, given that these funds have four-year investment periods.
Moving on to open-end funds, 2014 also produced a mixed investment performance story, given a trend toward risk-bearing for much of the year, declining security prices in the second half, and performance concentrated in a few standout securities for some benchmarks. For example, in our high-yield bond and senior loan strategies, people often expect Oaktree to excel in more challenging credit markets like we saw in 2014. That’s understandable, given our emphasis on risk control and our historical outperformance in down markets.
But our real strength is in constructing portfolios that perform with the market but embody less risk of default. In 2014, defaults generally continued to run at below average levels, meaning our potential to add value by avoiding them was quite limited. As a result, we generally did not outperform our benchmarks in these categories.
In US convertibles we underperformed the index by 6% in 2014 because, unlike the benchmark, we never hold securities whose underlying stocks soar to the point that the convertibles become what we call equity substitutes. Given this bias, our 2014 return was roughly what it should have been relative to the 5% gain for the Russell 2000, which is the index that’s usually most closely correlated with convertibles.
To anticipate a question, let me address the impact of falling oil and other energy prices.