The strategy is emblematic of the words no financial firm or investor wants to hear: “too much money chasing too few deals”, of which the looser financial covenants and arguably egregious EBITDA addbacks in recent debt deals are merely a symptom.
Marks points to the massive fundraising numbers for direct lending, something that PDI data has shown, with the amount for senior debt raised last year totalling $65.57 billion, the most on record. The amount of capital for senior debt grew every year from 2012-2015 before dipping in 2016 and rocketing back up last year.
“Has direct lending reached the point at which it’s wrong to do?” he writes. “Nothing in the investment world is a good idea or a bad idea per se. It all depends on when it’s being done, and at what price and terms, and whether the person doing it has enough skill to take advantage of the mistakes of others, or so little skill that he or she is the one committing the mistakes.”
It is worth noting that Oaktree itself has made a concerted push to increase its presence in the direct lending space.
The Los Angeles-based firm, which declined to comment, is currently raising its Oaktree Middle Market Direct Lending Fund, which has collected approximately $720 million, executives said on the second-quarter earnings call.
In addition, Oaktree bought the two business development companies from Fifth Street Asset Management last year, renaming them Oaktree Specialty Lending Corporation and Oaktree Strategic Income Corporation.
“Consistent with Oaktree’s investment philosophy, we plan to manage the existing portfolios and originate new loans with an emphasis on fundamental credit analysis and downside protection,” said Edgar Lee, the CEO of both BDCs, in a statement announcing the purchase close.
In his memo, Marks also emphasises how green some money managers are.
“Nobody who entered the market in nearly ten years has experienced a bear market or even a really bad year, or seen dips that didn’t correct quickly,” he writes, adding that “newly minted” firms have yet to “learn firsthand the importance of risk aversion”.
Marks goes on to provide real-life examples from of potentially “imprudent” deals Oaktree’s portfolio managers have seen. While all the transactions are cautionary tales, one stands out as a marquee example of the market behaviour that has made some alternative lenders nervous.
A buyout fund purchased Company E, a “terrific company”, for 15x adjusted EBTIDA and put leverage of 7x adjusted EBITDA on the business. The adjusted EBITDA though is 125 percent of reported EBITDA putting the valuation and leverage multiples at 19x and 9x, respectively, of reported EBITDA.
“We aren’t saying this will wind up being a bad deal,” the Oaktree investment professional who saw the deal told Marks. “Just saying that IF this ends up being a bad deal, no one will be surprised. Everyone will say, with the benefit of hindsight, ‘they paid way too much and put way too much debt on the balance sheet, and it was doomed out of the gate’.”
This is not to say that investors should completely avoid credit managers, Marks said.
“I’m absolutely not saying people shouldn’t invest today, or shouldn’t invest in debt,” he concludes. “But for me, the import of all the above is that investors should favour strategies, managers and approaches that emphasize limiting losses in declines above ensuring full participation in gains. You simply can’t have it both ways.”