Net Net: Promoting innovation and managing change
Net Net: Promoting innovation and managing change

Och-Ziff attracts billions despite tepid performance, legal concerns

Dan Och
Amanda Gordon | Bloomberg | Getty Images

Och-Ziff Capital Management Group grew to be one of the largest hedge fund firms in the world by convincing clients it could deliver relatively modest but steady returns as a stable and safe steward for institutional investors.

2014 has tested Och-Ziff's conservative reputation. Mediocre performance combined with negative press around business dealings in Africa have helped push the stock price down more than 15 percent for the year at one of the few publicly traded hedge fund firms.

But the big-money investors who make up Och-Ziff's client base have added billions of dollars to the firm's coffers, especially to new loan and real estate offerings. Combined with performance gains, assets under management have increased $5.9 billion from Dec. 31 to Sept. 1 to $46.1 billion.

"Even though the absolute number is not terrific this year, I still think they are meeting those expectations of their investor base, which has a pretty voracious appetite for risk-adjusted returns," said Citigroup analyst William Katz.

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The firm's flagship hedge fund, OZ Master Fund, is up 2.57 percent through August net of fees. The fund's gains in credit-related investments were subdued by losses on Asian and European stocks, according to public disclosures.

The Absolute Return Multistrategy Index, which averages the performance of similar hedge funds that make diverse bets on various types of securities, gained 4.03 percent through July and is likely higher given the market's broad rise in August.

Och-Ziff's Europe-focused fund also fell 1.47 percent this year through August; its Asian vehicle declined 4.25 percent over the same period.

A spokesman for Och-Ziff declined to comment, but billionaire founder Dan Och made note of the fresh client cash despite tepid returns.

"As you see from the numbers, the investors are very comfortable with our long-term capabilities and how we deal with short-term issues that don't quite measure up to our expectations," Och said in an earnings call on Aug. 5. The OZM Master Fund produced annualized returns of 10 percent from inception in 1998 through 2013.

Despite that confidence, stock investors have punished Och-Ziff this year on the bad press.

In March, Och-Ziff disclosed in a filing that, beginning in 2011, it had received subpoenas from the Securities and Exchange Commission and requests for information from the Justice Department related to potential violations of the Foreign Corrupt Practices Act, which prohibits bribery to gain business abroad.

Och-Ziff's stock fell as related news trickled out, including potential bribery of people connected to Libya's sovereign wealth fund around 2007 and investments in mining and oil businesses in the Democratic Republic of Congo.

Read MoreDOJ probes finance firms' dealings with Libya: WSJ

Rubenstein: Private equity & hedge funds attractive
Rubenstein: Private equity & hedge funds attractive

More recently, Och-Ziff shares dropped nearly 7 percent on Aug. 22 when a Bloomberg Businessweek story, "The Hedge Fund and the Despot," resurfaced allegations by U.K. human rights watchdog RAID that the hedge fund essentially financed political intimidation and violence in 2008 by Zimbabwean President Robert Mugabe by investing in a mining company that then gave a financial lifeline to the cash-strapped dictator's regime.

The Zimbabwean embassy in Washington, D.C., did not respond to a request for comment. A spokesman for Och-Ziff has denied any connection to the country's politics and described the investment as "passive."

"It doesn't get any uglier than that in terms of a headline," said one observer who counsels institutional investors on hedge funds and is not permitted to speak publicly about his clients' investments. The person said that while the bad press and underlying accusations weren't a deal breaker for investors, it could influence allocation decisions when viewed together with tepid returns.

"They hire a firm like Och-Ziff to be the 'sleep at night' fund," the person said. "When the ballast underperforms and gives you headline risk, it begs the question as to why it's there in the first place."

Morningstar analyst Stephen Ellis agreed that the firm's hedge fund clients could be spooked.

"Clients I think can be rightly concerned about Och-Ziff's investment processes and may feel a bit more leery about putting more assets with Och-Ziff," Ellis said.

Ellis and others have noted that some hedge fund investors were frustrated that they hadn't been notified separately of the government investigations besides the public disclosure in March.

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Ellis and other stock analysts are still optimistic despite those issues.

Ellis believes the stock's fair value is $15, although the target is down from $17 in April.

"In 2014, we can see clear signs of improvement at Och-Ziff," he wrote in a client note on Aug. 8 that noted the firm's expansion into credit and real estate offerings.

Citi's Katz has a "buy" rating on the stock with a price target of $15. He noted the growing appetite of institutional investors for alternative investments like hedge funds, especially large ones and those that can generate relatively smooth returns in both up and down markets.

Katz said that Och-Ziff's hedge fund performance was far more important than hits to its reputation.

"My outlook is positive," he said.

JPMorgan analyst Kenneth Worthington also recommends the stock and believes shares will rise to $17.

"We like Och-Ziff stock, and see upside in 2014/2015 based on multiple expansion, supported by a high dividend," Worthington wrote in a research report on Aug. 6.

A recent Goldman Sachs report was "neutral" on the stock with a price target of $13, slightly higher than the current price. The analysis said that the stock could rise on strong fund performance but said it could suffer because of "regulatory overhang, softer performance, slower flows (and) higher-than-expected expenses."

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—By CNBC's Lawrence Delevingne