My Favorite Takeaways from the Oaktree S-1

On July 17th, Oaktree Capital Group filed its S-1 with the Securities and Exchange Commission. Many times over the past few years, we have profiled Oaktree's Chairman Howard Marks and highlighted takeaways from speeches he has given and his fantastic memos on Oaktree's homepage. In addition, I just started reading Marks' "The Most Important Thing", described by Warren Buffett: "This is that rarity, a useful book." If it's good enough for WEB, it's damn well good enough for me. When I am finished, I will put up a thorough review of the book.

With all that said, I read through Oaktree's S-1 and thought it would be a useful exercise to pull out my top 10 takeaways from the document. For those that want to follow along, you can find the S-1 here: Oaktree S-1

Enjoy.

1) Oaktree explains value investing REALLY well

In their "Business Principles", Oaktree lays out a number of fundamental tenets that guide their operation as an investment manager (commonality of interests, management fee arrangements, etc). The first business principle is "Excellence In Investing" and they go for the jugular in explaining how they do it - i.e. value investing:

"Our goal is excellence investing. To use, this means achieving attractive returns without commensurate risk, an imbalance which can only be achieved in markets that are not 'efficient'. Although we strive for superior returns, our first priority is that our actions produce consistency, protection of capital, and superior performance in bad times."

To me this speaks massively of margin of safety and the first AND second rule of investing: "Don't lose money." Further down in the document, when speaking about the investment philosophy, this quote appears:

"We believe that the best long-term records are built more through the avoidance of losses in bad times than the achievement of superior relative returns in good times. Thus, our overriding belief is that 'if we avoid the losers, the winners will take care of themselves.'"

2) Oaktree likes to play in the top part of the capital structure

Similar to commentary we've seen out of Marty Whitman and the Third Avenue Focused Credit Fund, Oaktree likes to play high up in the capital structure to minimize their downside with the possibility of equity upside in the case of the seniors being the fulcrum. That is not to say that Oaktree is going out and buying par loans, but in recent cases where they have been active (Tribune, Universal Building Products, Almatis), they are playing in the most senior part of the capital structure and buying the debt significantly less than par. From the S-1

"Most of our investment strategies focus on debt securities and many of our funds’ investments reside in the senior levels of an issuer’s capital structure, substantially reducing the downside risk of our investments and the volatility of our segment’s revenue and income. Debt securities by their nature require repayment of principal at par, typically generate current cash interest (reducing risk and augmenting investment returns) and, in cases where the issuer restructures, may provide an opportunity for conversion to equity in a company with a deleveraged balance sheet positioned for growth."

3) Oaktree Knows When to Sell It Own Equity Well

In May 2007, Oaktree sold 15% (23,000,000 shares) of its company on Goldman Sach's private exchange valuing the company at $6.3B or a price of ~$40/share Here is the trading prices for the equity on that same exchange:

They struck while the iron was still hot in 2007 and did a service for their selling investors by not waiting. Of course they could have waited until today, but that 4 years can be a long time for people with high percentages of their net worth in illiquid stock. In addition, if you consider that at the end of 2006, when they were probably marketing this equity sale, their AUM was around $35B versus $80B today. The intrinsic value of the stock is substantially higher today that it was 4 years ago and they still sold at those levels. AND they had the thesis that we were going into an economic downturn to top it off (see next bullet point). Well played.

I also did not know they had sold equity prior to the 2007 listing; From the S-1: "We first sold a piece of Oaktree to outside investors in 2004 and again in 2006, when long-time clients acquired approximately 13% of the company."

4) They grow when the going gets (or is about to get) tough

Many times when speaking with new and emerging fund managers I hear the complaint that the best time to raise capital is when we are staring over the abyss, but at that point no one wants to allocate capital. The irony in asset management really is the best returns (and hence incentive fees) arise when its hardest to raise capital. Oaktree, and a number of other prominent distressed investors (Baupost for example) have bucked this trend. Sticky capital the answer? Here is an example from the S-1

"By way of example, from January 2007 until May 2008, in anticipation of an economic downturn, we raised $14.5 billion for two distressed debt funds, including $10.9 billion for OCM Opportunities Fund VIIb, L.P., or Opps VIIb. We commenced Opps VIIb’s investment period in May 2008 and then invested over $5.3 billion of its ultimate $9.8 billion of drawn capital in the 15 weeks following the collapse of Lehman Brothers on September 15, 2008. While that investment environment presented an outstanding opportunity for us to buy bank debt and other securities at distressed prices, the steep drop in the financial markets contributed to the $10.8 billion decrease in aggregate AUM market value in the year ended December 31, 2008. Markets recovered in 2009, resulting in aggregate appreciation of $19.1 billion and $8.7 billion in the years ended December 31, 2009 and 2010, respectively. The recovery in the financial markets continued into the first quarter of 2011, driving further aggregate market appreciation in AUM of $3.2 billion."

In addition, and the other side of the coin to this, is that they shrink when markets are frothy (I've noted in the past how they return capital early when opportunities do not exist). In the S-1, Oaktree comments that "this phase in the market cycle is likely to cause our AUM to decrease in the second quarter of 2011 and to then possibly plateau or continue decreasing in coming quarters, subject to net asset flows in other funds and fluctuations in market value across all funds."

5) Oaktree and I Think Alike on Distressed Debt

A fundamental tenet of my thought process on distressed debt investing is as follows: Increased and sometimes frantic demand for high yield paper (bonds and lev loas) is met by underwriters marketing weak companies, weak collateral, and weak covenants. This in turn leads to higher default rates and lower recoveries for credit on the aggregate which leads to lower pricing of the asset class as a whole. This is when you buy credit - not when an underwriter tells you he is marketing a covenant lite retailer levered 6x on ADJUSTED EBITDA and the book is 3 times oversubscribed.

From the S-1 (long one here - I apologize, it was too good to cut out any of it)

"One important factor we consider in assessing where we are in the cycle is the amount of debt issuance, such as high yield bonds and non-investment grade leveraged loans. We believe an increased volume of debt issuance, to the extent it reflects loosened credit standards, can foretell an increase in debt default rates and the distressed securities they often create. The chart below shows this historical correlation.

We size our distressed debt funds based on the above relationship, our assessment of the economic cycle and other factors. By sizing funds in this manner, we intend to avoid both managing too much capital when bargain purchases are scarce and too little capital when they are plentiful. As a result, we have achieved positive gross and net IRRs as of March 31, 2011 for each of our 15 distressed debt funds. The chart below illustrates two benefits of our approach to sizing funds: the consistency of our positive performance and that, in each cycle, our largest funds have tended to be our best performers. Each bar represents a distressed debt closed-end fund, the height of the bar corresponds to the fund’s gross IRR as of March 31, 2011 and the dollar amount below each bar identifies the fund’s committed capital.

In 2001 and again in 2007, we anticipated the possibility of market dislocation, based in part on the considerable amount of debt issuance in the preceding years. While we did not attempt to predict the timing of the downturn, we thought the volume of lending relative to the fundamentals created a dynamic in which issuers would likely have difficulty meeting their obligations, resulting in an increased default rate or other factors that could result in expanded investment opportunities for us. Accordingly, we raised considerably more capital than we had historically so that we would be prepared if the markets experienced financial distress, creating attractive buying opportunities."

6) Their results are incredible

I had never seen the below chart, where their distressed debt returns were showing in one listing. I had heard the rumors but never the data to back it up. Needless to say, this is a glorious chart (click through if its too small). And the thing that really sticks out at me: No negative numbers here: