Howard Marks: $400 Million Invested In Energy-Related Securities In Q4

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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.

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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. Across the entirety of Oaktree funds, as of December 31 energy represented about 8% of our holdings. Needless to say, some of those holdings fell in price, contributing in part to the low returns in certain funds during the second half of 2014.

The good news is that we had better buying opportunities, which we were quick to exploit. For example, in the fourth quarter our distressed debt and value opportunities funds invested about $400 million in energy-related securities.

On the open-end fund side, we are underweight energy in many strategies. The biggest strategy, US High Yield Bonds, hold 13% in energy as compared with the benchmark’s 16%.

For the past three and a half years, Oaktree’s mantra has been: move forward, but with caution. With the recent arrival of some disarray and heightened risk aversion, events tell us it’s appropriate to drop some of our caution and substitute a degree of aggressiveness.

Thus it’s timely that we have commenced a sizable fundraising program for closed-end funds. Jay will address that topic; but first David will cover the financial highlights, as usual.

Mike Carrier – BofA Merrill Lynch – Analyst

Thanks, guys. Just first question, I guess, Howard, you went through some of the performance strengths and then some of the challenges in the quarter. So partly a question for you and then partly for David, just wanted to understand.

It looks like Opps IX, the performance in the quarter took a bit of a — had some pressure. So just wanted to understand: what drove that? What’s the outlook here for the Fund?

Then, David, you mentioned in the text just in terms of the acceleration on the ENI side, what that can do to the mark-to-market. So just wanted to understand that and if any other funds contributed to that.

Howard Marks – Oaktree Capital Group, LLC – Co-Chairman

Mike, it really is what I said. We got tagged in a couple of equity positions; and since the environment during Opps IX’s life has been nondistressed, that fund has done rifle-shotting rather than a shotgun approach like Opps VIIb, which had large numbers of distressed companies to choose from. So it’s a — you start off with a more concentrated portfolio, and in some cases you convert positions. You either take positions in debt — in equity, or more likely convert positions into equity.

And then as it happens, some of our industries were the ones that were in decline in fourth quarter, obviously, like energy. So we don’t think that the performance in the fourth quarter says anything about the long term, but we ran into a considerable bout of volatility.

Another example I think would be drybulk shipping, which — we’ve taken a large and diversified position in shipping, and drybulk was doing the best. And in the fourth quarter that reversed and drybulk did the worst.

But nothing fundamental changed, and we don’t think that it has any implications for long-term performance.

I’ll just add, in conclusion, that these are the periods that make us glad that we don’t take incentives created onto the financial statements. And so we never have — we are never faced with having to unearn income that we previously recognized.

Jay Wintrob – Oaktree Capital Group, LLC – CEO

Thanks, Mike. I’m going to cheat a little bit. I think there’s probably more than one in both categories. But, look, I think there’s opportunities at Oaktree for improvement across the board. There’s really no — nothing that off limits.

But I mentioned earlier the Firm’s is in excellent shape and the opportunities are just to make it better. Obviously I think in the area of products the Firm has done a very good job the last few years in establishing new open-end and evergreen strategies; plus bring in the Highstar group, which will be the backbone of the new infrastructure fund later this year. I would hope that there’d continue to be no shortage in creativity about possible new opportunities in the future that may arise there.

I think on the distribution side, with the launch of our two new mutual funds in December, which are still very, very early in their life, it’s obvious though that Oaktree is underweight exposure in retail, subadvisory rearrangements, also in the management of insurance money as compared to its core Limited Partners in the pension, both public and private, side and endowment side. So there’s opportunities there.

And roughly three-quarters of our clients are based inside the United States and only a quarter outside the United States. So obviously without going region by region, there is opportunity there. And I think there is a lot of activities in flight to accomplish things in all three of those areas: product, distribution, and geography.

Then in terms of focus, it’s fair to say, initially I’ve spent more time internally and less time externally — meeting people, becoming comfortable, so I could be authentic about what I’m speaking about. I think that my background in operations and managing a large organization has me, at a minimum, asking an awful lot of questions, asking for an awful lot of data. And I think through that process we will find opportunities to become more efficient, possibly to do things a little bit differently, that allow us to leverage our people more.

So I’d say there’s opportunities throughout, both on the growth side and also in terms of over time improving our profitability.

Howard Marks – Oaktree Capital Group, LLC – Co-Chairman

I would like to add one word, Jay, and that word is systematic. What I see in what Jay is doing is that he is taking a systematic approach to understanding and managing our operations. That illustrates in good part why we brought him in, because he is a professional manager, whereas his predecessors were not.

I think that his systematic approach, while not dogmatic or inflexible or mechanistic, can’t help but have a great effect.

Michael Kim – Sandler O’Neill & Partners – Analyst

Hey, guys. Good morning. First question, just given the volatility in the credit markets more recently that you mentioned, just curious where you stand in terms of being able to fully capitalize on opportunities that may present themselves. Has the scale or timeline for Opps X and Xb shifted at all, just in light of making sure you have the capacity in place should things start to maybe move a bit more quickly?

Howard Marks – Oaktree Capital Group, LLC – Co-Chairman

Well, we have about $10 billion in dry powder at the present time, which is a lot of money. And as you know, we are targeting another $10 billion for Opps X and Xb. The first close of those funds is days away, and we think that it will be a substantial close.

The beauty of the B fund structure is that it gives us flexibility, and the recent events do a lot to illustrate the need for or the desirability of flexibility. If the distressed environment were to remain slow, then after completing Fund IX we would have a $3 billion Fund X — approximately $3 billion, based on our targets. If the environment were to darken further, such that there is more distress, then at our option we can swing into investing the capital for Fund Xb whenever we want.

So the point is we’re going to have a lot of capital; we already have a lot of capital with which to move if it’s appropriate. And especially through X and Xb but also the other funds that we talked about we’re going to have a lot more.

Flexibility is not inherent in the investment management business, especially in the closed-end fund business. But our A/B structure which we’ve been using for the last — well, we actually imagined it 25 years ago, has given us a lot of flexibility and permitted our best-performing funds to be our biggest funds.

Michael Cyprys – Morgan Stanley – Analyst

Okay, thanks; that was helpful. I guess just on the deployment side, I think Howard mentioned real estate and Europe are areas of deployment opportunities right now. Just curious if you could elaborate a bit more around that, just in terms of the types of real estate properties or specific geographic regions.

Howard Marks – Oaktree Capital Group, LLC – Co-Chairman

Well, in the States obviously when you have a big gain like we had in our funds in 2014 it indicates that prices have been on the move. So one side of the coin is appreciation, and the other side of the same coin is the diminution of subsequent opportunities.

But we think that the opportunities in commercial in nonprime cities and non-A buildings is still superior. It’s an area where for the most part we think prices are not back to pre-crisis highs in the US. So we are continuing to be quite active in the US.

At the same time, we are also active in certain parts of primarily Western Europe, such as Germany and the UK, with less activity elsewhere. The US and Europe constitute the vast majority of our activity.

Jay Wintrob – Oaktree Capital Group, LLC – CEO

And if I might — back on the prior question, Howard, if I might, on the real estate, I just wanted to say that continued low interest rates obviously helped a lot of the borrowers refinance — effectively kick the can down the road. But speaking with John Brady and his team, I think the volume of what they like to call zombie real estate — real estate that continues to be worth less than the face amount of its debt, but debt that has very, very low debt service — continues to be ample.

So the circumstances could change relatively quickly over the next several years, where you have a lot of debt maturing on real estate that is not worth as much as the face value of the debt. John and his team have made that an important part of their real estate efforts. I know they continue to track that like a hawk. So it gets another opportunity down the road possibly.

Howard Marks – Oaktree Capital Group, LLC – Co-Chairman

Then I’d like to, as they say in the Senate, extend and whatever — my remarks. Your question I only answered about real estate. I didn’t answer about European activities per se, non-real estate.

I just want to say that we see continued very strong deal flow of loan pool offerings. We do not feel that there is any reduction in the opportunity from that source. It has been strong for about two years now and continues to be very good.

Brian Bedell – Deutsche Bank – Analyst

Great. Maybe just a follow-up. Howard, you talked about you didn’t know what to root for in terms of the bull or bear markets. Obviously it’s a tough call to try to predict what will happen.

But am I right in surmising that, as you are raising the $20 billion over the next six quarters in closed-end funds, plus the raises on the open-end and evergreen funds, that you feel like you are coming into a much stronger fee-related earnings profile that would potentially offset any negative marks from downward pressure on credit?

Howard Marks – Oaktree Capital Group, LLC – Co-Chairman

I would prefer to say that there is a good chance we are coming into a better period in terms of securing investment opportunities. We have three jobs to do: raise money, invest it well, and harvest when the time comes. Really the most important moving part for us I think is the invest-it-well part.

By definition you can’t invest it well and harvest well at the same time. In high markets you harvest; in low markets you invest.

The whole train or process starts with good investments. So we are not going around high-fiving in an environment like 2013 or 2014 where the investment pickings are slim. We prefer it when securities are in the bargain basement, and investors are depressed and panicky and forced sellers. We haven’t had that. And we feel that if we buy cheap, there will always come a time eventually when we can sell dear and harvest more earnings and incentives.

As I say, the whole thing starts with buying cheap. And we kind of lick our lips when the market becomes more in disarray.

And there is a chance of that. There’s a chance of that.

There is no ground on which to predict it at the present time, merely to say that within the investment period of Opps X and Xb, Real Estate VII, and Power IV, and some of these other funds we’ll hit the 10th anniversary of the crisis. And recessions don’t come along like clockwork, but 10 years since the last one usually gives us reason to believe that the market — that the economy may be less than buoyant.

Howard Marks – Oaktree Capital Group, LLC – Co-Chairman

Let me — if I can say one thing to get away from the nuances, there are three things at work here in establishing the fees we show. Number one is the mix, which David spent a lot of time on. Number two is the timing, which David spent a little time on.

The third factor, which I don’t think David mentioned, is the level of fees per product. And in answer to your question, I believe it’s safe to say that the level of fees in our products is essentially stable. So I don’t feel price pressure on the fees in Opps or Real Estate or Power or the EM or whatever it might be, or Strategic.

Things come and go because of mix and timing. But as long as the underlying fee rates are stable, then that’s, I think, the most important thing and the best we can hope for.

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