Embracing the cycle

It's hard to believe it was just the end of June when Henry Kravis declared private equity had entered its “golden era”.

While it might be a little premature to declare this period officially over, some unsightly tarnish has appeared. In the short time since Kravis' comment, the top end of the corporate credit market has frozen, a string of mega-buyouts have been jeopardised, and some traditional private equity firms are considering “non-core” investment strategies in a market that some would struggle to characterise as good, let alone golden.

But for those well positioned to profit from the turbulence, such as Los Angelesbased alternative asset manager Oaktree Capital Management, times have just become a whole lot better.

“Our view is we've been going through a very tough time for a bargain hunter because prices have been elevated and there's been very, very easy access to money. And also there's been a total absence of distress,” says Howard Marks, Oaktree's co-founder and chairman. “So the world's been a free and easy place, and that's why it's got to the state it's in now, with this credit crunch.”

Howard Marks

He adds: “We're probably going into a period where attitudes are less positive, and capital is not so easily available, prices are not bid up so much and there's some distress. For us, that's better times. That's when we start to smile.”

Marks, 61, has much to smile about. Regarded for his wit, candour and contrarian thinking, Marks was raised in a middle-class neighbourhood in the New York borough of Queens and first earned a reputation as a junk bond genius working for Citicorp Investment Management from 1978 to 1985.

Fast-forward several decades to the present, and one finds Marks living in Los Angeles and London, in possession of a $1.4 billion personal fortune that ranks him 361st on the Forbes 400 list (alongside fellow Oaktree cofounder Bruce Karsh), and running one of the largest, most ambidextrous and fastest-growing alternative investment houses around.

BRANCHING OUT
Oaktree's investments straddle different asset classes and involve both short- and long-term approaches, but the 12-year-old firm's signature strategy has always been distressed debt investing. Indeed, nearly $13 billion of its $47 billion under management is accounted for by distressed debt funds, which Marks says employ a different strategy from most rivals in the space.

In line with a standard private equity fund model, Oaktree's distressed debt funds have a ten-year life, GPs are paid after the LPs and there is an 8 percent hurdle rate.

“My impression is that a lot of distressed investors have migrated to the hedge fund format,” Marks says.

Oaktree's private equity investments are effectively an outgrowth of its distressed debt activities. Having observed that it was frequently ending up the controlling shareholder in a company after exchanging its debt for equity, Oaktree set up its Principal Group specifically to do distressed debt-for-control deals

“Then we got into periods like '96-'97 when there was no distress, and our distress-for-control activities morphed into opportunistic private equity,” Marks says. “So now our principal funds do distress-for-control and private equity – whichever is available.”

In either case: “You have to be able to sit on the board, help run the company, sit on strategy [boards], and do all the things that private equity firms do.”

We're probably going into a period where attitudes are less positive, and capital is not so easily available, prices are not bid up so much and there's some distress. For us, that's better times. That's when we start to smile

In 1999, Oaktree began offering power infrastructure-focused funds, a pure private equity play, and continues to add funds dependent on the buyout industry. In 2001, it launched a mezzanine arm, and this year, the firm is said to be raising a $3 billion hung bridge fund, specifically to buy LBO debt that underwriting banks are unable to syndicate, in addition to a $3.5 billion principal fund.

BIGGER ISN'T BETTER
Marks declines to comment on fundraising specifics but says his firm tends to adjust its fundraising in accordance with the markets, and doesn't shy away from shrinking funds and turning away capital.

“Our clients think it's one of the greatest things we do,” Marks says. “Back in '93 we told everybody they could put in half as much as they put into the previous fund, and everybody gave us big pats on the back. Why should it be that regardless of the cycle, every fund has to be bigger than the last one? That doesn't make any sense.”

He adds: “A good money manager is one who puts the client first and says ‘This isn't a good time, the market's not attractive’. That's a badge of honour, if you ask me.”

The need to make such decisions is one good reason, Marks says, as to why Oaktree chose to float a portion of its management company on Goldman Sachs' private exchange as opposed to a public exchange.

“Back in '04 there wasn't anything to do in the distressed debt world. So we raised a $1.2 billion fund, a third the size of the previous one,” Marks recalls. “What if public shareholders started calling up and saying, ‘You idiot, you could have raised $10 billion? We're going to vote you out if you don't raise $10 billion’?”

He continues: “The right thing was to raise $1 billion, because there was little to do, even though we could have raised $10 billion and maximised fees in the short run. But that wouldn't be the way to maximize Oaktree's value in the long run.”

The firm thought it compelling to stay private so long as it could find a way to generate the same sort of liquidity created by a public listing. “I think we have the best of both worlds,” Marks says.

CULTURAL CURRENCY
When Fortress Investment Group went public in February, Marks reckoned a trend was in the making that would give publicly listed alternative investment management companies an advantage, “mainly in hiring, retaining and motivating employees, but also for acquisitions of other money managers”.

“Back in '93 we told everybody they could put in half as much as they put into the previous fund, and everybody gave us big pats on the back. Why should it be that regardless of the cycle, every fund has to be bigger than the last one? That doesn't make any sense.”

But for cultural and financial reasons, he felt listing on Goldman Sachs' private exchange was a better option for Oaktree than listing on a public exchange like Fortress or The Blackstone Group chose to do.

“Ours is not a steady growth rate business. The thought of having to enunciate a growth rate and then make it happen is very unappealing,” Marks says. “One of the greatest problems in American business is short-termism. Avoiding it is among the good reasons to stay private.”

As, he says, is avoiding the expense a publicly traded company incurs to comply with the Sarbanes-Oxley Act. “We don't mind disclosure but we don't want to spend unneeded millions to do it,” Marks explains.

Oaktree listed approximately 15 percent of its management company on the Goldman Sachs Tradable Unregistered Equity exchange, or GSTrUE, in May, raising $880 million. Its lead was followed in August by Apollo Management, which raised $828 million on the exchange.

A failure to list, Marks said, “would have turned a great positive – which is Oaktree's broad employee ownership – into a negative”. Between 1995 (when the firm was founded) and 2005, Oaktree put roughly one-third of its stock in the hands of 80 employees. “And if they see Apollo and Fortress and Blackstone going public, and they see their stocks are extremely valuable, they could resent it if we didn't make our company stock valuable,” Marks says.

GLOBAL REACH
Bargain hunting for deals in inefficient markets has led Oaktree far and wide. Aside from several US locations, it has large teams in London and Frankfurt, offices in Tokyo, Singapore, Hong Kong and Beijing, and an affiliate in Luxembourg.

It has led the first-ever public-to-private transactions in Poland, with its acquisition of vodka producer Lubelskie Zaklady Przemyslu Spirytusowego Polmos Lublin which completed earlier this year, and Taiwan, where its $1 billion bid for golf club head maker Fu Sheng received government approval in July.

Most recently, Oaktree purchased Singapore-based Pangaea Capital Management, a pan-Asian, special situations real estate investment firm, in a move to further strengthen its Asian real estate deal flow.

Oaktree has pushed hard into Asia in the past two years. In November 2005 it opened its third regional office in Hong Kong; earlier this year it appointed Ralph Parks, former chief executive of JP Morgan Asia Pacific, as chairman of its Hong Kong subsidiary; and in August, the firm closed its first Asia-specific private equity fund, OCM Asia Principal Opportunities, on $577 million.

WHAT GOES WHEREOaktree's assets under management as of 30 June 2007

	Assets
	($m)
Marketable securities
US high yield bonds	10,930
European high yield bonds	1,643
US convertibles	3,709
International convertibles	3,213
High income convertibles	831
Closed-end private investment partnerships
Distressed debt	12,795
Principal activities (for control)	6,976
Power infrastructure	1,479
Mezzanine investments	1,612
Real estate	1,378
Evergreen Funds
Emerging market equities	1,528
High yield plus	549
Japan opportunities	454
European credit opportunities	273
Total assets	47,370

Source: Oaktree