Oaktree Deal Raises Distress About Private Fund IPOs
Can the average stock market investor make money investing in Wall Street’s exclusive private-equity and debt trading clubs?
As investors are tempted once again to tap rarified trading profits that were once available to only the smartest Wall Street minds and the world's richest investors, the tepid response to the initial public offering from the industry's largest distressed debt manager, Oaktree Capital, suggests more investors answered this question in the negative than bankers expected.
Investors are right to be skeptical of this IPO crop — Carlyle Group is hoping to follow Oaktree and begin a road show next week.
Oaktree (with $75 billion in assets under management) placed 8.8 million shares — lower than its original goal of 11 million shares — at the bottom end of its price range, or $43. Thursday’s deal raised $380 million for Oaktree, as it lists shares on the New York Stock Exchange under ticker “OAK.” Shares fell lower than the IPO price in Oaktree’s debut morning of trading. In an ironic footnote to the Oaktree deal, one of its restructuring investments, Aleris International, a once-bankrupt steel manufacturer, scrapped a planned IPO on the same day that Oaktree priced its lackluster deal.
The Oaktree deal comes amid a poor performance run for several of the private-equity players that have already gone public, including Blackstone Group, KKR & Co., Apollo Global Management, Fortress Investment Group, and Och-Ziff Capital Management.
Blackstone Group shares are off roughly 50 percent since its 2007 IPO, while Fortress and Och-Ziff have fared even worse since hitting stock markets. Among recent listings, Apollo’s shares are off roughly 20 percent, while KKR is a rare alternative asset manager in the green, posting a 30 percent-plus stock gain.
It would be a mistake, though, to view the weak Oaktree deal as a sign that the alternative asset manager can’t be an attractive investment. The issue may be that investors view these companies in the wrong light as Wall Street tries to take them public. Analysts that cover alternative asset managers argue that the sector needs new stock valuation methodologies altogether.
If the alternative asset manager sector is to live up to expectations as publicly traded stocks, understanding the return profile of these companies is the starting point for a re-evaluation. As opposed to being the latest Wall Street snake oil, focusing on management fees and the expectation of increasing investment gains indicates alternative managers may be poised for strong, stable earnings, and dividends.
Private-equity and debt-focused funds may offer above average returns for their limited partner investors, but those returns don’t go directly to public shareholders. Shareholders get a taste of the potential manager investment savvy by way of secondary management fees — smallish 1 percent to 2 percent fees paid to firms opening funds with billions in investor assets — and on a share of the manager’s realized investment gains on those funds, usually paid out in dividends.
Greggory Warren, a senior stock analyst with Morningstar, says that because of their complicated limited partner structure and the potential that firms won’t easily be able to raise new funds to replace ones that are expiring, stock investors may be better served investing in traditional asset managers like Franklin Resources, Invesco, Affiliated Managers, and Blackrock with more direct earnings streams.
“At the end of the day, you are better off being invested in one of those fund [managers] than you are investing in the units of these publicly traded firms,” Warren concludes.
Oaktree’s IPO filing shows that while its closed-end funds have posted an internal rate of return of nearly 20 percent on over $50 billion in invested capital in 2011, overall earnings available to prospective shareholders — called distributable earnings — fell over 20 percent to $488.5 million from $635 million in 2010.
Still, investors have reason to consider tapping the proprietary investment style of firms like Oaktree, which is diminishing as a component of bank earnings as new regulations like the Dodd-Frank Act kick in. There isn't a single analyst sell rating among the five publicly traded alternative-investment management firms. That’s because analysts argue that stock investors don’t fully appreciated what they are getting with shares in private-equity firms.
“Across our capital markets coverage universe, the shares of the alternative asset managers — Apollo, Blackstone, and KKR — are among the most volatile of all firms that we cover. Yet from our perspective, there are unique features of these business models that make them among the most defensive and stable franchises across our coverage,” wrote Credit Suisse analyst Howard Chen in a February note assessing how the sector should be valued.
While firms’ preferred earnings measure is called “economic net income,” which represents management fee earnings and quarterly marks to unrealized investments — less performance attributable to direct fund investors, taxes, and compensation expense — Chen argues that investors should focus on the cash that firms earn for shareholders via fees and their interest in realized investment gains. It is these cash earnings that helps give firms like KKR and Blackstone above 5 percent dividend yields and that can drive share prices higher. IPO Desktop President Francis Gaskins told TheStreet that Oaktree’s dividend yield could exceed 7 percent based on its filings.
Over the next three years, Chen expects Apollo, Blackstone, and KKR to increase their fee earning assets under management, with 2012 being a watershed year of 20 percent-plus growth. Meanwhile, performance fees on assets under management are expected to rise to nearly 3 percent from sub-2 percent levels by 2014, adding billions in revenue for the three firms. Chen highlights Apollo as benefiting the most from growing management and performance fee earnings.
“Despite the potential for accelerating cash flows in 2012 and 2013, in our view, valuations of many alternative manager stocks remain inexpensive and not reflective of their potential earnings power,” notes KBW analyst Robert Lee in a December assessment of the sector. Lee also notes that long-term commitments to funds, and the pullback of investment banks from private-equity and proprietary funds, provides these managers with a consistent set of cash-based earnings.
While firms’ net income may swing wildly depending on market activity, similar to investment banks, cash earnings may be more stable and reflective of financial sector above average dividend yields. The Blackstone Group and KKR are Lee’s top picks within the sector.
Investors still unclear on how to pick winning alternative-asset manager stock may also look at whether insiders are selling stakes in IPOs.
In Blackstone’s blockbuster 2007 IPO that has since underperformed significantly, the company's co-founders Peter Peterson and Stephen Schwarzman both sold significant stakes. Meanwhile, KKR’s co-founders Henry Kravis and George Roberts haven’t sold their shares, as the company’s stock has performed strongly since a July 2010 listing.
Oaktree Capital Management was co-founded in 1995 by Howard Marks and six executives from the money manager TCW Group. Marks, who holds about one-sixth of the company’s shares, and his partners, earn money on investments in distressed debt, real estate, convertible bonds, and direct company ownership, mirroring the strategies used by some of the world’s largest hedge funds.
In Oaktree’s share offering, management were large share sellers as the company's chairman Marks and president Bruce Karsh cashed out roughly 40 percent of the IPO proceeds, according to a March regulatory filing. Other existing shareholders such as hedge funds Farallon Capital Management, Maverick Capital, JMG Capital Partners, and Scroggin Capital Management were expected to sell an additional 1 million shares, according Bloomberg data gleaned from Securities and Exchange Commission filings.
The Carlyle Group is soon to be world’s second largest publicly traded private-equity firm when it sells a 10 percent stake in a May IPO, according to Bloomberg. In that filing, which is expected to fetch a valuation of $7.5 billion to $8 billion, Carlyle's co-founders won’t sell their shares.
For more on financial IPOs, see BATS Global Markets share crash. See five stocks that could be trampled by a share overhang, for more on private-equity backed IPOs.
Additional News: Oaktree Capital Shares Open 5% Below IPO Price
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