Howard Marks’ memos are treasured by Warren Buffett himself. Howard Marks’ book, The Most Important Thing received the following comment from Warren Buffett, ‘When I see memos from Howard Marks in my mail, they’re the first thing I open and read. I always learn something, and that goes double for his book.’ Marks’ latest memo noted some of his worries. Generally, Marks rarely speaks in public. However, now that his firm, Oaktree Capital Group LLC (NYSE:OAK), is public we get to hear from Marks at least on a quarterly basis. Oaktree released earnings on Thursday after the market close, and we have obtained a transcript of the conference call. First a quick look at the earnings followed by remarks from Howard Marks.
OAK reported 4Q12 ANI of $1.36/unit, vs. he Street’s $0.92. The beat came from stronger-than-expected incentive and investment income, along with tax-related distributions from Opportunities Fund VIIb, (Fund “Opps VIIb”). Growing realizations contributed to 4Q distribution of $1.05/unit (including an approximately $0.34 tax distribution), while net accrued incentives ended at $8.50/unit. The firm announced it has already recognized about $195 mn in incentive income this year in Opps VIIb.
OAK beat on higher incentive income from record exits/distributions. Fee-related earnings (FRE) was a bit lower sequentially as slightly higher mgmt fees (+1% q/q) were offset by higher core expenses (+3% q/q), but the margin remained healthy at ~39%. Core trends were strong with $5.7B of CEF distributions (driven by Opps VIIb), $1.0B of net fundraising (driven by $0.6B each from CEFs & OEFs offsetting $0.2B of Evergreen outflows), & positive returns led to new incentives created equal to the strong incentive income recognized ($1.3B net accrued inc).
Howard Marks – Oaktree Capital Group LLC – Chairman
We are pleased to report strong financial performance for both the fourth quarter and full year 2012, including record annual quarterly revenues, distributable earnings, and distributions to unitholders. This performance was the result of compelling investment returns as well as a record year for closed-end fund realizations and distributions, resulting in strong incentive and investment income proceeds.
Across the firm, our investment teams delivered the type of performance that is the hallmark of Oaktree’s risk-adjusted, value-based investment approach. This permitted our clients to participate in the bull market for credit and garner equity-type returns in our opportunistic strategies.
First, I’d like to discuss the environment that led to an approximate 15% return across all of our funds during the year. Most public markets were quite strong in 2012. US markets did very well despite general uncertainty that pervaded investor sentiment in the months leading up to the US presidential election and then the fiscal cliff. Europe rose as the gloom receded, following bullish pronouncements from Brussels. In particular, credit continued to excel globally based on strong demand for income, liquidity, and the safety of contractual returns. Private equity, real estate, and other alternative market strengthened in concert with the equity markets as risk lightened.
Most of our closed-end funds participated in the year’s positive developments. These included the modest growth of the US economy, acceptance of the fact that a housing recovery has begun, improved investor psychology, accommodative capital markets, and strong investor demand for riskier assets that offer the prospect of higher returns. The Opportunities Funds showed an aggregate gain of 23.5% before fees and 19.1% after. Keep in mind that those returns, as almost all of our results, were achieved essentially without leverage at the fund level. Despite the low incidence of distress and thus the limited supply of bargain-priced investment opportunities, we were able to bring Opps VIIIb to 75% drawn.
Principal Funds followed a very similar pattern of rising asset prices and improved liquidity, although the gains for private investments generally come through slower than for public ones. Since our deal flow in this area arises more from company-specific challenged circumstances than from macro conditions, we were able in 2012 to both make several attractive new investments in some cases and realize existing ones.
In particular, 2012 allowed excellent exits from Jackson Square Aviation, which actually closed early in 2013, HD Supply, Nordenia, Spirit Airlines, and Cequel Communications. These exits contributed significantly to our global Principal Funds gaining 15.6% before fees in aggregate and 13.3% after. However, the uncertain environment and lack of economic progress in Europe limited the aggregate gain in the European Principal Funds
to 4.4% before fees and 2.6% after.
It continued to be the case the whereas deal flow was only moderate for the Opportunities and Principal Funds, it is strong and provides attractive, risk-adjusted returns in real estate and related debt. Prices are still soft for non-class-A buildings outside the leading US cities and the ability to refinance the debt on some of those properties is limited. This situation is creating some of our best investment opportunities today, as we continue to be able to buy properties and the debt on them well below their peak prices. On the other hand, improved psychology surrounding CMBS and housing as resulted in appreciation on assets we bought in those areas 1 to 3 years ago. In fact, now we read that the inventory of unsold homes is inadequate, quite a change from the prevailing belief a few years ago that there’dld never be another house built in the US. That’s the kind of swing in thinking that we try to take advantage of, and I think we are in this case. As a result, our Real Estate Funds saw an aggregated gain of 19.1% before fees and 14.7% after. In 2011 we made significant progress on Real Estate Opportunities Fund V, raising capital and investing it as we raised it. Now, ROF V is fully invested and we are raising ROF VI and investing it. We remain convinced that real estate and real estate-related debt offers the best combination of quality and quantity at this time.
And I want to take a minute out, reflecting on what I just said. I want to delete the word spectacular. We are making good investments in the principal funds, but I think it’s hyperbole on my part to say spectacular, and I retract it.
Moving on, importantly for our clients as well as our financial results, the strong market allowed us to distribute $12.7 billion from 27 different funds in 2012. Although that’s a record total, the distributions were vintage Oaktree in their demographics. In particular, they were extremely diversified without dependence on any single or handful of investments.
Our clients appreciate the premiums we attach to returning capital and profits to them in cash. I once titled a memo, “You Can’t Eat IRR.” Thus, no matter how impressive our funds’ IRRs may be, it’s the amount and timeliness of cash distributions of those profits that I think distinguishes us. For example, Opps VIIb won’t reach the second anniversary of its liquidation period until May 1. And yet, following last week’s distribution, it already has returned all $9.8 billion of its sdrawn capital and distributed $3.7 billion of its $8.6 billion total gains to date, including paying off the entire preferred return.
Cash is good for clients and it’s good for unitholders as well. It drives incentive income, which in 2012 reached an all-time high with 46% of the year’s total falling in the fourth quarter. So what’s the result of 2012’s strong investment returns, record realizations, and distributions of capital? It was sizable and high-quality earnings and cash flow in the form of distributable earnings. Given the sustained strength in management fee revenue, the diversified nature of our incentive income model, and the substantial investment income proceeds derived from distributions from our funds, as well as DoubleLine, we have declared a $1.05 distribution for the fourth quarter, bringing the total for 2012 to $2.94. The distribution we have announced represents a yield of more than 2% in the quarter alone, and that’s an unannualized figure, of course.
As good as 2012 was, the future looks promising as well, because as large as our incentive income was in 2012, the new incentives created by ourfund performance were almost twice as large. Over the course of the year we grew our off-balance sheet receivable, called “accrued incentives (fund level)”, by 25% to $1.3 billion, net of compensation expense, or $8.52 per operating group unit as of year-end. Underlying that $8.52 are 24 funds already in liquidation. Clearly, the star of that group is Opps VIIb, which we announced this morning has made its first distribution in 2013. Thus, with the first quarter just halfway over, we already are assured of meaningful incentive income and a substantial quarterly distribution. Keep in mind that nearly all of that fund’s $1.7 billion of incentives created through 2012 have already been taxed and, thus, their distribution will not be taxable.
In addition to the value we are creating through our current funds, we are also continuing to offer new strategies to provide the opportunities that our nearly 1800 investors are seeking in this low-return world, namely respectable yields with a downside protection of credit. These new products typically are organically developed as step-outs — or what we call adjacencies — to existing Oaktree strategies. They include our Enhanced Income Fund, Strategic Credit, real estate debt, and emerging market distressed debt. John Frank will elaborate on our capital expectations for these. So, for now, I’ll simply say that I’ve never been more excited about the potential for us to deliver our expertise in credit with the risks under control in so many markets.
Now, make no mistake, we’re telling investors to expect lower returns from the investments we’re making today than from the ones we are currently harvesting. To do otherwise would be irresponsible.
But, of course, as that’s happening, the same buoyant markets that require those lower expectations are permitting us to realize profits from our maturing funds and investments. All the while, the cycle marches closer to the time that, inevitably, the next downturn will come into view, turning today’s free-flowing extension of credit into tomorrow’s distressed debt, and permitting us to raise bigger funds again. Through it all, our clients continue to view Oaktree as the dependable purveyor of investment management in a growing number of alternative asset classes.
That dependability also extends to our unitholders, we are proud to say, with the end of 2012 marking our 17th straight year of positive adjusted net income, our 15th consecutive year of incentive income, and our 67th consecutive quarter paying a distribution.