Oaktree Capital: Thoughts on Valuation

Oaktree is an asset management company that specializes in the high-yield bond market and distressed debt.  Oaktree is lead by Howard Marks, who is famous for the Memos he publishes periodically.

Oaktree Presentation from the Bernstein Conference

At the end of last May, Jay Wintrob, CEO of Oaktree Capital presented at the Bernstein Strategic Decisions Conference. What particlularly caught my attention was the following slide:

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Oaktree Capital Presentation at Bernstein Conference, slide 13

According to the presentation, Oaktree Capital have access to $20 billion of committed capital that is currently undrawn, out of $100 billion of assets under management. Hence, they have been preparing by stocking up dry powder.

In terms of the opportunity set, it can be argued that the current environment in the high-yield bond market is unprecedented in terms of its scale. The current amount of low-quality debt exceeds the volumes that existed prior to the most recent bond crises’ by multitudes and far exceeds the dry-powder currently available to Oaktree.

OAK at Bernstein

Thoughts on OAK stock and valuation

As you can see from the slide above, we are at a very interesting point in the credit cycle. Most likely due to Quantitative Easing, there is now a dislocation between the volume of debt and high-yield default rates. Other sources also site that high-yield bonds have almost never in recorded history been as covenant-lite as now. If this bubble bursts, it might be the biggest opportunity for Oaktree Capital since its foundation. With the Fed pushing up interest rates, there is an indication that this is already in motion.

The historical IRR of Oaktree strategies

In the 2017 annual report, Oaktree posts a table which shows the historical average IRR of the different investment sectors that they are involved in. Distressed debt is not only, by far, the biggest asset class that they target, it is also where they obtain the highest yields.

Oaktree funds historical IRR
Source: Oaktree Capital 2017 10-K

A Simple OAK Thesis

Over the last years, OAK has distributed essentially all income attributable to it’s Class A unitholders (see below). From this, two assumptions can be made:

  • Even in the difficult environment of recent years in the distressed debt market, OAK has remained highly profitable.
  • Oaktree Capital is a highly scalable business, with almost no need to retain earnings to grow. In other words, they don’t really need capital to increase Assets Under Management.
OAK income statement
Source: Oaktree Capital 2017 10-K

Currently, book value per Class A share stands at roughly $13.6. This means that the units are currently around 3 times Book. At the same time, the dividend yield is over 9%.

So, if we simplify the thesis into a decision tree with two nodes of likely outcomes, it would look something like this:

  • Status Quo: The current high yield/distressed debt environment prolongs and you will own a security yielding around 6-9%.
  • The Market Reverts. Interest rates rise to their historical average, a huge chunk of high yield bonds go into distress. Oaktree will have around $20 of undrawn capital to deploy earning gross yields in excess of 20%.

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