Oaktree Capital: Invest with the Best

Oaktree Capital (OAK) is a well-respected alternative-asset manager, with nearly $100B in assets under management (AUM). One of its co-founders is Howard Marks, whose memos (and book) are Exhibit A in level-headed thinking.

Their primary specialty is debt securities, although they have exposure to other asset classes like real-estate and equities.

AUM have increased from $36B in 2006 to nearly $100B currently. This is despite their reluctance to grow assets for the sake of growing them. One of their tenets is “profit should stem from performance“.

They are shrewd opportunistic operators. They raise capital in anticipation of major market dislocations, begin sowing when everybody else is scared that the world is crashing around them, and then reap the fruits over the next few years. They tend to be a good counter-cyclical bet, even as they surf pro-cyclical waves with remarkable dexterity.

Generally, as Marks oncee remarked, OAK’s funds mildly underperform their benchmarks during good times (by about 50 bps), and greatly outperform them (by about 600 bps) during lean times. On a risk-adjusted basis they consistently outperform most of their benchmarks, over full cycles.

Their quarterly presentations (link to Q2 2016) provide a good overview and snapshot of their operations.

Valuation References

Like many financial institutions, I find it hard to to parse the details of OAK financials. Fortunately, many smart investors and bloggers have taken a shot at valuing OAK. These include:

  • The Brooklyn Investor looked at OAK just before its IPO, and after its 2012 results. He also looked at valuing OAK’s stake in DoubleLine, and concluded that at that time, its contribution to OAK’s valuation was still marginal. This asset might become incredibly valuable in the future.
  • OAK has been written up multiple times at Value Investor’s Club (2010, 2012, and 2014).
  • Elgethun Capital Management did a writeup (pdf) in 2014.
  • Broyhill Asset Management did a presentation “Solid as an OAK” in 2012, and seem to be still invested in it.

My Valuation

From the links above it seems best to value OAK using a sum-of-the-parts analysis. They have four drivers of value:

  1. Their balance-sheet (and off-balance sheet accrued incentives)
  2. Their sticky management fees
  3. Their incentive fees, which allow them to keep 20% of returns if they meet a 8% hurdle.
  4. Their return on their own investments (investment income)

The first driver can be valued on an asset basis, while the remaining three can be valued on an earnings basis.

In the first analysis that I present, there is some obvious double counting (although it will turn out to be unimportant to the valuation). Some of the assets on their balance sheet are used to generate investment income. So I cannot add the asset and the earnings that the asset generates.

Why? Suppose, I have an house worth $100K that generates annual income of $10K. I can either value the asset directly ($100K), or use a multiple of earnings (12x, say) 12 * $10K = $120K. However, I cannot add these two $100K + $120K = $220K to value the house. This would clearly be double-counting.

Valuation using Current Numbers

Okay, so in the Q2-2016 presentation, OAK lays out some numbers that help me with the valuation.

Balance Sheet

The BVPS is $11.25, and the net accrued incentives/share are $4.98 ($771M). This gives us $16.23 in assets on the balance sheet. The net accrued incentives account for incentive compensation, although I am not sure if it also accounts for taxes.

In the first pass, I don’t try to value Oaktree’s 20% stake in DoubleLine. It is carried on the balance sheet at a ridiculously low figure ($16M), but since the income generated flows through the investment income line item considered later, for the sake of being conservative, I err on the side of undervaluing this asset.

Fee Related Income

Not all the AUM generates management fees. As of year end 2015, out of the $97B in AUM, $79B generated management fees of $754M. The blended management fee has hovered around 1% since 2008 (currently 0.96%). Subtracting compensation and SGA, OAK earned a fee related income (FRI) of $190.6M for 2015.

This number is smaller than the average of about $283.5M since 2008. Currently, as markets have bounced back from 2008, OAK has shifted to a “reap mode”. If the market (or some portion of it) doesn’t correct, then OAK might not find good opportunities to get into “sow mode”, and we will have more of the same.

Overall, FRI has gradually decreased from over $300M in 2011-2012 to under $200M in 2015, even as fee-generating AUM (FG-AUM) has increased modestly, primarily due to the increase in compensation expenses.

Currently OAK has 154.8M shares outstanding. Thus the FRI/share is $190M/$155M = $1.23. These are pre-tax numbers. Using Buffet’s 10x PTI rule for high-quality businesses (and management fees at OAK are sticky), we get a 10*1.23 = $12.30.

Incentive Income

OAK earns 20% of profits if they can generate returns greater than 8%, on their incentive earning AUM (currently ~$32B). After accounting for incentive compensation (45-55% of incentive income), the incentive-based PTI for 2015 was $122M. This is significantly lower than the average of $226M since 2008.

Incentive income is not as sticky as management fee based contributions to profit. So we should use a lower multiple (say 8x). Thus, this accounts for 8 * $122M/$155M ~ $6.30/share.

Investment Income

In 2015, OAK had $48.5M in investment income. Using a 10x multiple, this contributes $3.12/share.

SOTP

Adding up all the parts, I get $16.23 (balance sheet) + $12.31 (FRI) + $6.30 (Incentive Inc.) + $3.12 (Investment Inc.) = $38/share.

Qualifiers

To use Howard Mark’s metaphor of a pendulum that swings between extremes, one could argue that the pendulum is currently is closer to the “overvalued” extreme (as market valuations hit all time highs, oil bankruptcies nowhere in sight, and bond yields go underground).

As the tide turns, OAK will probably revert back to more “normal” earnings. OAK has raised significant capital to plough in, if things get ugly.

If we use averages since 2008 for FRI ($18.31/share) , incentive income ($11.70/share), and investment income ($7.57/share) instead of FY 2015 numbers, we get, a much higher SOTP estimate of nearly $54/share.

Once can also try to value DoubleLine separately. The Brooklyn Investor in one of the posts linked to above suggested that the value of DoubleLine might be 1%-2% of its AUM. DoubleLine has indicated that it doesn’t want to grow beyond $100B.

This would suggest, at an upper end, 2% * $100B = $2B value for all of DoubleLine. Considering OAK’s 20% ownership, this would amount to 20% * $2B = $400M = $2-$3/share of OAK. So the contribution is still marginal.

Conclusion

Overall it seems like OAK is worth $38/share based on today’s depressed earnings. Normalized earnings suggest a higher $54/share value.

This does not give OAK any special credit for growth. Given its track record of growing AUM, this is perhaps an overly conservative estimate of OAK’s value. OAK’s numbers are going to be lumpy, but over entire cycles, one should expect them to do very well.

OAK also has high-quality management. It is among the most desired alternative asset managers. Generally, it is a good idea to stick with high-quality companies like OAK through thick and thin, rather than trading around the position.

OAK can add value to a portfolio due to its counter-cyclical bent, providing real diversification benefits. It also brings exposure to debt securities, for portfolios heavily invested in equities.

 

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