Oaktree Capital Management is now stepping into the fray of senior debt with its debut senior-only private fund, a move that comes at a precarious time as more firms are chasing both investor dollars and deals that target the upper portion of the capital structure.
However, Middle-Market Finance Group portfolio managers Bill Casperson and Raj Makam are confident the demand is there for its senior debt fund because the firm’s private equity sponsors kept asking when it would launch such a product.
“The sponsors are telling us, ‘We need another player in the market,’” Makam says. “And, frankly, we asked, ‘Why do you need another player? There are so many players in the market.’ One guy just told me, ‘Yes, there are, but we need someone with a consistent approach to the business.’”
That Oaktree’s private equity sponsors have urged the firm to invest in senior debt is not new, the two men say. Across three vehicles, the firm has already invested $893 million, according to an investor presentation to the San Joaquin County Employees’ Retirement Association.
One of Makam and Casperson’s initial forays in the strategy was out of the firm’s Mezzanine Fund II – a 2005-vintage vehicle that carried a flexible investment mandate – at the urging of the financial sponsors it worked with.
“Our sponsor clients wanted us in the senior debt business even that far back, and there weren’t as many senior-dedicated vehicles out there that our LPs could invest in,” Casperson says. “So, when we approached the market for Mezz Fund II, we told our LPs we wanted to do both senior and mezz, and they were fine with that.”
Another attempt at fleshing out a senior strategy came in 2011 when, according to the SJCERA presentation, Oaktree invested $48 million in North American senior loans from a business development company. In addition, in 2014, the firm began work on a Middle-Market Senior Loan Fund, a mid-market collateralised loan obligation warehouse, as a means of investing in mid-market senior loans.
When crafting the fund structure, Casperson and Makam prioritised identifying the right fee structure. This, they reasoned, would allow them to pursue what they deemed safe assets – although priced lower – while still delivering the results investors expected.
“You’ve got L+475 or 500, which is a plain-vanilla first lien,” Makam says. “If you’re doing an L+625 paper and calling it first lien, it’s clearly a different risk profile than the normal first lien. So, what you do is say, ‘I want to focus on the safest quality deals in the market, and I’ll still give you the return investors expect on a generic basis.’ The only way to do that is to change your fees – dramatically change them.”
Documents show that neither the BDC vehicle nor mid-market CLO charged an incentive fee. Makam and Casperson declined to comment on the fee structure for the BDC, CLO or in-market private fund, and it was unclear whether the BDC lacked an incentive fee because it never garnered outside capital or whether it was a conscious decision.
Makam says Oaktree has internalised the importance of fees.
“We know how the fee structures shape the way you do business,” he says. “We’ve taken that out of the equation and said, in this market, where we are, we need to be focused on one thing, which is the highest-quality, lowest-risk deals and do what is best for investors.”
According to a study from London-based advisory firm bfinance, the average charged by a US senior debt direct lending fund – the exact type of vehicle Oaktree is raising – is a 1.3 percent management fee with a 15 percent incentive fee and a 6 percent hurdle rate (as of the first quarter).
Incentive fees can range from 10 percent to 20 percent, says Dharmy Rai, an associate at bfinance, who notes that the lack of an incentive fee is not unheard of but is not the standard, either. She explains it is “usually for a lower-returning strategy, and not necessarily done for a special situations strategy”.
Incentive fees can vary depending on whether the fund uses a European-style incentive fee structure or the US-style arrangement – on a fund level or a deal-by-deal basis, respectively. However, more vehicles are trending toward the European style, she says, meaning investors will receive their principal back plus their preferred return, or hurdle rate, before the manager sees its portion of the incentive fee.
Management fees have fallen alongside a compression in credit spreads, Rai explains. Four years ago, a management fee of 1.5 percent was common, but this has now fallen closer to 1.3 percent, as the study outlines.
For senior-only US vehicles today, Rai says she has seen a range, from about 0.6 percent to 1.5 percent, with around 1 percent being a common fee structure. What can vary, however, is how the fee may be structured for a vehicle levered at the fund level – specifically, is the charge levied on equity commitments or total assets, which would include the levered capital?
“More managers are going towards equity commitments, [which is] partly in line with the number of US funds seeking foreign capital.”
A longer version of this article will appear in the July/August issue of PDI.