|Shares Out. (in M):||519||P/E||0||0|
|Market Cap (in $M):||1,665||P/FCF||0||0|
|Net Debt (in $M):||131||EBIT||0||0|
What is the most hated industry right now? U.S. bricks and mortar retail? The auto industry? Mexico? I would humbly submit another contender that many of you are likely familiar with: the hedge fund industry. A few recent samples:
Long Och-Ziff (“OZM”) as an opportunistic trade. The stock has been demolished (down -38% in the last year vs a +18% market, down -77% in the last three years, and down -90% since IPO) owing to an ugly confluence of industry challenges and company-specific issues: investing underperformance, ongoing redemptions, a dividend cut, and fears around a lengthy FCPA investigation and $412M settlement. On street estimates (which seem reasonable but likely low), OZM is being valued at ~5x ‘18E P/E, which is a 40% discount to its historical average, a 30% discount vs other alternative asset managers, and a 46% discount vs traditional asset managers. We think there is a genuine need for alpha-focused vehicles on the part of institutional capital and OZM continues to be a name brand in a space where that matters. While we can’t say for certain that OZM will be able to stabilize its assets and generate attractive returns, if it can, the stock could be worth 2-3x where it trades today. This is more of a warrant, so size accordingly.
Och-Ziff Management (“OZM”) is the only publicly traded hedge fund and has $33.5B in AUM. Up until recently, almost the entirety of the firm’s AUM was invested in several different multi-strategy funds, the largest of which is the flagship OZ Master Fund (now <$19B AUM). In recent years, the business has diversified to include an opportunistic credit business ($5.3B AUM), a CLO business ($7.3B AUM), and a real estate business ($2.1B AUM). It has a fairly simple economic model:
· Revenue = Mgt Fee (% of AUM) + Incentive Income (% of Profits, subject to HWM)
o Vast majority of incentive income earned in Q4
· Expenses = Salary & Benefits (managed as % of Mgt Fee)
+ Other expenses (managed as a % of Mgt Fee)
+ Cash Bonus (generally targeted as a % of Revenue)
· Revenue – Expenses = Economic Income
· Less Taxes: Distributable Earnings (DE)
· Share count tends to grow each year (~3-5%) as part of additional incentive comp
· Historically ~90% of DE is paid out as a dividend on a quarterly basis
What Has Happened to the Business and Why is the Stock down so much?
Until the end of 2013, OZM had been plugging along just fine.
· Its returns in its flagship fund had been good (+11.6% in ’12, +13.9% in ‘13), which, while less than the S&P, was achieved with far less volatility (2% vol vs S&P at 9% vol) and highly attractive Sharpe ratios (2.83 five year Sharpe ratio at the end of 2013). While this might seem unattractive to the folks on VIC (we prefer a lumpy 15% over a smooth 8%), it is important to remember there is a large group of investors out there who have high demand for a lower return but lower volatility product. That preference is not simple economic irrationality. By the end of 2014, the flagship fund had AUM of $28B.
· OZM was beginning to successfully diversify into other funds and asset classes. It now had a $10B AUM credit business, a $2B AUM real estate fund and several other non-multi-strat funds, which now accounted for 28% of overall AUM. Its total AUM was $47B at the end of 2014.
· While overall earnings were lumpy due to investment performance, the company had a good track record of substantial earnings generation ($355M in ’09, $461M in ’10, $200M in ’11, $538M in ’12, $894M in ’13, $600M in ’14). 90%+ of these earnings were paid out in dividends.
· While OZM traded at a discount to traditional asset managers, between 2008-2014, it traded right in-line with its alternative asset manager peers
Since then, OZM has been hit with a confluence of ugly events: weak investment performance, a FCPA investigation and settlement, redemptions, a management fee reduction on the multi-strat funds, increased operating expenses and a dividend cut.
· In 2015, OZM’s flagship multi-strat fund was down -0.28% vs the S&P up 1.38%. In the fourteen months from June 2015 – July 2016, the fund had negative performance in 7 of the 14 months and was down -5.7% vs the S&P up +5.7%.
FCPA Investigation and Settlement:
· I could write an essay on this but the key takeaways are the following:
o Between the years 2007-2010, the head of OZM Europe, Michael Cohen and his analyst, Vanja Baros, engaged in some very bad behavior in Africa that triggered a FCPA investigation
o Both of them left the firm in spring 2013
o This was a very lengthy investigation and culminated in a $412M settlement in September
· As a result of poor investment performance and some investors’ fear of the FCPA charges, we saw significant net outflows ($1.2B in 2015, ~$8.5B in 2016).
Management fee reduction:
· In August 2016, OZM agreed to reduce management fees by 25bps on its multi-stat funds.
Increased operating expenses:
· As the FCPA investigation dragged on, legal fees took their toll, and non-comp expense went from running at $30M per quarter to a peak of $52M in Q1 2016. They have since fallen to $39M and we expect them to decline further.
· In order to ensure sufficient capital to fund the FCPA settlement, OZM ceased paying a dividend in November 2015.
Where are We Today?
· OZM’s flagship funded ended 2016 up +3.8% and has seen very good performance in the 2H of the year.
· OZM’s credit business and real estate funds have also posted excellent returns.
· While we saw large redemption activity in Q4, we expect far fewer redemptions going forward as the dust settles from the FCPA investigation and investment performance has rebounded. One other thing to highlight: over the past couple years OZM has mainly seen outflows but very little inflows. This is largely because while many investors were not willing to pull out capital from the funds, they weren’t willing to go to investment committees to put more capital in, even for new unrelated funds.
· Since the settlement, OZM has closed its first European CLO (€413M), re-fi’d its third U.S. CLO that was launched in Feb 2013, and launched a new U.S. CLO ($409M).
· This is now behind us. The settlement is being funded with a combination of cash that was not dividended out, as well as a new $400M preferred security. The $400M pref was funded by Dan Och and other partners. It bears zero coupon until Feb 2020, at which point it steps up to 6%. We expect it will be taken out before it begins paying any interest.
What’s the Risk-Reward?
This is a challenging investment in that the two things that matter the most – what returns OZM will generate and what AUM will be (which over time is related to the first) are highly unknowable. This is part of why we think the price is attractive. It is not inconceivable that the business falls into a vicious cycle of poor returns, shrinking AUM, employee departures, etc. However, if we assume that AUM stabilizes, investment performance is acceptable, expenses fall as the investigation is wrapped up, and the dividend is reinstituted, it’s easy to see enormous upside. Our base case could see DE of $0.70, which at 8x P/E (OZM’s long-term average) would be a $5.60 stock. A more bullish branch could see DE of $1.15, a 10x multiple (a discount to its 12x prior peak) and a $11 stock. And, yes, there is a branch where things get very ugly and this is worth far less than it is today. However, unless you think the probability of that branch is quite high (which we do not), the risk-reward seems highly attractive at the current price.
Improving investment performance
Stable or growing AUM
Reinstitution of dividend