‘Deals like this don’t grow on trees’

Oaktree Capital Management wasn’t looking for a partner when Brookfield Asset Management approached it. Founder Howard Marks discusses the merger, and what lies ahead for private markets

For all those who wondered if consolidation would reach the upper echelons of alternative asset management, Brookfield Asset Management’s purchase of Oaktree Capital Management is your answer.

The spate of M&As in the alternative asset space had largely been limited to smaller money managers, including the business development company sector, a space in which Oaktree purchased two management contracts for this specific type of mid-market lending vehicle.

Brookfield plans to acquire 62 percent of Oaktree, with Oaktree co-chairmen Howard Marks and Bruce Karsh and other firm members retaining the other 38 percent.

From 2022, former employee unitholders will be able to sell their Oaktree units to Brookfield through an agreed liquidity schedule, as will Oaktree’s founders, management and current employee unitholders. Under this scheme, Brookfield could own 100 percent of Oaktree by 2029.

Bruce Flatt, Brookfield’s chief executive, approached Karsh, also Oaktree’s chief investment officer, about the deal, Marks tells sister publication Private Debt Investor. The target firm had not been running an auction process or retained an investment bank in anticipation of a merger.

Oaktree had developed a list of requirements, though, after rumours in 2002 of an interested party approaching the firm about a deal.

“It had to be a prestigious affiliation from a party willing to pay a fair price to obtain a non-controlling interest in Oaktree that would remain freestanding and autonomous, managing itself and where the other party would not try to interpose itself between us and our clients,” Marks says.

Though Brookfield will hold a majority economic stake in Oaktree, the latter’s senior management and other senior members will still control the voting rights.

“Bruce Flatt’s expression was he could spend 10 years trying [to build a credit arm] and maybe not end up with what we [Oaktree] have today,” Marks adds.

“This is a fundamental transaction. It would have been right a year ago, it would be right a year from now … There’s nothing about timing that should be inferred from our action”

Some financial pundits have speculated this deal represents Marks calling the top of the cycle, which he categorically denies.

“It’s not a timing thing,” he says. “Remember, of course, we didn’t initiate it. This is a fundamental transaction. It would have been right a year ago, it would be right a year from now. It happened to pop up today. So, there’s nothing about timing that should be inferred from our action.”

The union with Brookfield presents a win-win for both firms on the strategy front: Oaktree lacked a robust presence in real assets, while Brookfield did not have much of a credit product.

“We decided deals like this don’t grow on trees,” Marks says. “There aren’t many Brookfields in the world. It’s [a] very well-respected pure play in alternatives, which shares a culture with us and [has a] very good operating record, and we think it’s very well run.”

Outside observers say the transaction more than makes sense for the buying party.

“[Brookfield’s] purchase of Oaktree in that context is a very logical progression of private credit through asset-gathering,” one investment banker says. “Independent private credit franchises will be very valuable in this environment.”

But the effects go beyond this. If approved, the transaction would also represent the next chapter in Oaktree’s ownership saga, taking Oaktree itself private. Brookfield would acquire the selling firm’s public partnership units, though Brookfield itself is a publicly traded company.

Oaktree has wrestled with multiple ownership structures for years – public or private? Maybe somewhere in between?

Oaktree, which went public in April 2012, was never an ideal candidate for public markets; it’s something Marks anticipated even five years before Oaktree listed on the New York Stock Exchange.

“Back in ’04, there wasn’t anything to do in the distressed debt world. So, we raised a $1.2 billion fund, a third the size of the previous one,” Marks told sister title Private Equity International in 2007, referring to OCM Opportunities Fund V. “What if public shareholders started calling up and saying, ‘You idiot, you could have raised $10 billion? We’re going to vote you out if you don’t raise $10 billion’?”

In 2007, Oaktree decided to dip its toe into the waters of listed securities. It put approximately 15 percent of its management company on the Goldman Sachs Tradeable Unregistered Equity Securities market, thereby raising $880 million.

The firm raised $10.94 billion for its global financial crisis-era flagship distressed debt fund, the 2008-vintage Oaktree Opportunities Fund VIIb, which returned a 2.0x multiple on drawn capital and a 16.6 percent net internal rate of return.

With a lack of distressed opportunities currently, the market finds itself in a similar position to 2004, and Oaktree has made a similar decision, delaying the beginning of its investment period – the point at which LPs would begin paying fees on committed capital – for the $8.87 billion Opportunities Fund Xb. The decision has limited its management fee income. “We do not expect management fees to grow until the start of the investment period of Ops Xb, which we still estimate will be in the second half of 2019,” chief financial officer Dan Levin said on the firm’s fourth quarter 2018 earnings call in February.

Even in times of relative famine for distressed investors, though, Oaktree has found opportunities to invest: Opportunities Fund X, which exited its investment period in January, has a 1.4x multiple on drawn capital and a 16.8 percent net IRR as of 31 December.

It’s no secret Oaktree’s tenure as a public company didn’t hold up to pre-IPO expectations. Marks will certainly acknowledge as much. “It was not our motivation to stop being publicly owned, but I think that Oaktree and public ownership was not a perfect fit, and we’re willing to end that,” he says. “What I learned through our experience being public is that Wall Street really only gets excited about growth stories. We’re not a growth story.

“We grow when the investment opportunities in our sectors grow, but we don’t grow when they don’t. Other people grow all the time and have a growth orientation. Our stock, I would say, languished relative to theirs.”

The firm’s stock has remained illiquid, causing what Marks calls a “conundrum” for the firm: its pool of potential stock buyers was small, he says, leaving the firm limited liquidity. The solution people suggested? Get a larger pool of possible shareholders.

“Well, you can’t sell stock if you don’t have liquidity,” Marks says. “They’d say, ‘Oh yeah, if you had [a larger potential shareholder base], you’d sell more stock.’ So, it’s rather circular. We never figured out a solution to that, and the stock remained quite illiquid. I think the Brookfield transaction will do wonders for that.”

Oaktree has worked on growing its product set with limited success in some areas, but has remained synonymous with distressed debt for many. It had some difficulty in infrastructure, with one fund of Highstar Capital, a firm Oaktree acquired in 2014, not meeting expectations. It also ended up shelving plans for a commingled energy infrastructure fund, though it did raise a transportation infrastructure vehicle.

On the firm’s Q2 2018 earnings call, Levin highlighted growth in real estate, transportation infrastructure, emerging markets, senior loans and direct lending. Those strategies, he said, grew from under $10 billion in assets in recent years to more than $35 billion of assets at the time.

The Brookfield tie-up will take this into a different league. “This transaction provides [Oaktree] with the ability to extend their franchise beyond private credit,” an investment banker noted. “They’ve had relatively less success in gathering assets because they are seen as specialists.”

Marks concedes distressed debt returns have not been living up to investor expectations – but that is largely due to expectations being too high. “What return should you expect from distressed debt investing when the world is not distressed?” he says. “No asset class has the birthright of a return. A return comes from bearing risk, buying things well, maybe getting lucky on the way out, adding value while you own it. There has been very little distress, only a modest ability to buy at low prices, and so this has been a very tough period for distressed debt.”

Race to the bottom

The proliferation of private credit managers gives Marks cause for concern, particularly that a race to enter the asset class could lead to a race to the bottom in deal pricing and terms. In September, he published one of his widely read memos, which have come to shape how many people think about financial markets. Entitled The Seven Worst Words in the World, it referred to “too much money chasing too few deals” and cited direct lending as a poster child for excess.

Low returns across traditional asset classes have driven institutional investors to plough money into riskier alternative assets, leading to that outcome. Managers that raised too much in an over-exuberant fundraising environment may have been tempted into unsound investing and lending decisions under pressure to deploy capital.

“When a lot of new money hits a small-ish asset class, it tends to drive up the prices and drive down the quality of structure, and drive up the risk and drive down the prospective returns,” Marks says. “These are risky things. These are dangerous things.”

The fundraising bonanza for both private debt and private equity reached a high in 2017, according to PDI data. Private credit fundraising reached an all-time high of $211.34 billion, and private equity funds locked down $473.21 billion. There has also been a spike in first-time credit funds.

“Just think about what a first-time fund means,” he says. “It means a guy raises his hand and says, ‘I’ve never done this before, but I’d love to give it a try with your money,’ and people rush the stage to give him money. That tells you something about the investment climate.”

Marks points out that those who have entered private markets in the last 10 years have yet to live through any tough times. For those individuals, it’s harder to understand the importance of being vigilant about guarding against downside scenarios.

“What you learn when you’ve been in this business 50 years is that it’s not portfolio management. That’s a misnomer. It’s risk management. Credit decisions are not all created equal. There are better and worse credit decisions. You see three loan portfolios, one yields 9 percent, one yields 7 percent, one yields 5 percent: which is the portfolio that embodies the best credit decisions? The answer is you can’t tell. You’ll find out when the tide goes out.”

Those who derive comfort from the relatively muted impact the financial crisis had on private markets when compared with other areas of the economy should beware. “Financial history tells us what happens, but it doesn’t tell us what’s going to happen next time because the circumstances may be different.

“There’s much more low-quality debt out there today. Senior loans have much less that they’re senior to than before. Many, many loans are being made on the basis of adjusted EBITDA, which is what earnings will be if everything goes hunky-dory. So, extrapolating the past is very dangerous.”