From high-yield bonds and distressed investing to mezzanine and real estate debt, Oaktree Capital Management has been offering essentially every credit strategy an investor could want – except for a senior debt fund.
After earlier attempts, Middle-Market Finance Group portfolio managers Raj Makam and Bill Casperson hope third time’s the charm for a pool of capital dedicated to investing at the top of the capital stack. Oaktree chief executive Jay Wintrob revealed on the firm’s 2016 fourth-quarter earnings call in February that the credit investing powerhouse would offer a closed-end fund to invest in senior secured loans.
Embracing the new strategy comes at a precarious time. Much of the capital raised for private credit in the first quarter was for senior debt, meaning plenty of competition for a finite amount of dollars, with anecdotal evidence suggesting the trend may be continuing in Q2. Deal terms are loose and some transactions are getting done at double-digit multiples. Put simply, raising capital could prove to be easier than deploying it. However, Oaktree is 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.’”
A STRATEGY REVISITED
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.”
“Every LBO by a sponsor utilises senior debt. There are more opportunities to invest senior and select those assets than there is mezz”
The firm’s junior debt team decided to invest $670 million in North American senior debt out of Mezzanine Fund II, a vehicle that raised $1.25 billion in equity commitments, the SJCERA documents show. Fund II produced an 11.1 percent gross internal rate of return and a 7.6 net IRR as of 31 March, according to Oaktree’s earnings results.
Another attempt at fleshing out a senior strategy came in 2011, according to the SJCERA presentation, when Oaktree invested $48 million in North American senior loans from a business development company named Oaktree Finance, for which the firm provided seed capital.
The firm filed a registration statement in May 2011 indicating plans to take Oaktree Finance public at a time when a number of BDCs were doing so; in that year there were seven initial public offerings for such companies, the largest number in at least 10 years. Oaktree had hoped to raise up to $125 million, according to a February 2012 draft of the registration statement. The firm withdrew the offering in July 2012 for unspecified reasons, according to regulatory filings. The BDC vehicle never received any commitments of outside capital.
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. The warehouse has invested $175 million in North American senior loans, according to the SJCERA documents.
Before the multiple efforts to launch senior debt operations, Makam and Casperson joined Oaktree in 2001 from the high-yield desk at NationsBank to launch Oaktree’s mezzanine debt practice, alongside Bill Sacher, who subsequently migrated to Adams Street Partners to launch its private credit arm in January 2016.
“The opportunity at Oaktree was to form a mezzanine group to do junior lending for these mid-size sponsors and their LBOs,” Casperson says. “The Asian financial crisis resulted in the high-yield bond market really moving up its minimum issuance size from $75 million-$100 million to $200 million. So there was a giant void in the market for mid-size sponsors to find junior debt.”
Makam says the skill set he and Casperson developed in high-yield bonds prepared them to tackle junior debt in private credit. “Seeing that there was a different asset strategy where high yield wasn’t really playing anymore because of the size, we said why not employ the same risk standards and portfolio management standards we deploy in high yield and apply to an asset class that smells and feels like high yield – except it’s a little different,” says Makam.
Obvious differences include the illiquidity of mezzanine private debt versus the liquid nature of high yield and the need to source your own transactions in private credit. Oaktree launched its first mezzanine fund in 2001, raising $808 million for the strategy at a time when private credit was in its infancy. Of that total, $773 million was drawn, according to the SJCERA presentation.
The debut vehicle produced a gross IRR of 15.4 percent, a net IRR of 10.8 percent, and 10.5 percent for two separate classes of interests in the fund, according to Oaktree’s first-quarter earnings. The fund’s investment period ran from October 2001 to October 2006.
Fund IV is Oaktree’s latest mezzanine fund, which is still in its investment period until October 2019. So far, the vehicle has produced a gross IRR of 12.4 percent and a net IRR of 8.6 percent, as of 31 March. Investors in that fund include Virginia Retirement System, which allocated $250 million to the vehicle, and Kentucky Teachers’ Retirement System, which committed $40 million to the fund, according to PDI data.
Casperson and Makam prioritised identifying the right fee structure when discussing the strategy for its senior vehicle. 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.”
The SJCERA 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.
“On the non-sponsor side, we think it's a little bit of a misnomer where you can get higher return for lower risk”
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,” she says, noting there is a trend towards US GPs looking for investors abroad.
PICKING AND CHOOSING
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.”
When it comes to picking and choosing deals with or without a private equity sponsor, Oaktree will do both, but Casperson and Makam have a preference for those involving a financial sponsor.
“We certainly see non-sponsored deals, but the business primarily remains sponsor-focused because, from our perspective, the risk-reward we have seen, primarily the risk, is a lot better from the sponsor side,” Makam says, explaining that sponsorless deals have become more efficient recently.
He says non-private equity-backed businesses will frequently now bring in an advisor or outside party to help the process run more smoothly. That, in turn, partially negates one of the attractive parts of deals lacking a private equity sponsor: the extra legwork during the due diligence process put in by the alternative lender, which allows for a higher coupon for businesses that can provide a compelling risk-adjusted return. “On the non-sponsor side, we think it’s a little bit of a misnomer where you can get higher return for lower risk,” he continues. “That usually doesn’t happen because many non-sponsored deals nowadays tend to be financed, or at least go to market, with an intermediary in the middle. When that happens, it becomes pretty efficient and becomes a price game.”
Many large US pension plans have fleshed out their direct lending strategy in recent years, but there is still a demand for senior debt, despite the eye-popping fundraising statistics, notably Twin Brook Capital Partners’ $2.3 billion fundraise – split across both a commingled fund and separate accounts – and Crescent Capital Group seeking $1 billion for its second fund.
Since the financial crisis, with the continued retrenchment of banks from the mid-market and the need for additional yield in an era of low interest rates, private debt has come to prominence and taken up larger portions of LP portfolios.
There are many foreign investors looking to take part in the strategy, as Rai notes – particularly national pension funds in South Korea. The Construction Workers Mutual Aid Association recently committed $35 million to Park Square Credit Opportunities III – a senior debt origination fund focused on Western Europe, according to PDI data – while the country’s Public Official Benefit Association set aside an additional $300 million to $400 million for private debt, specifically senior secured lending funds or structured notes.
What’s more, there is still demand for it in the US, despite being a crowded market. Texas County & District Retirement System allocated $1.25 billion across three separate accounts over April and May for its direct lending strategy, while the Iowa Public Employees’ Retirement System is seeking to set up a $250 million separate account focused primarily on senior debt.
Another bfinance survey showed that as of March this year, of the firm’s five searches between November and February for senior debt funds, 21 percent of US vehicles were a first-time fund, whether the entrant was new to the private credit space or a credit firm’s first senior vehicle.
As more senior debt vehicles enter the market – to the tune of one-in-five US funds – the competition may be stiffer, but Oaktree will keep channeling its sponsors. “Our clients, the sponsors, still want to see us in the [senior lending] business,” Casperson says. “It’s a void in our product offering. And for our team that’s calling on the sponsors every day, having a junior debt product, it’s just a natural extension of our platform.”
A benefit of senior debt, Casperson says, is there are more deal opportunities because of how leveraged buyouts are structured. “You’ve got to be extremely discriminating in this type of environment if you’re doing junior lending and not every [LBO] deal utilises junior debt,” he says. “But every LBO by a sponsor utilises senior debt. There are more opportunities to invest senior and select those assets than there is mezz.”
That opportunity, identified by its own clients, has enabled Oaktree to slot into place what appears to be the last piece in its credit strategy puzzle.