Monday, October 24, 2011

The Brooklyn Investor - October 24, 2011

Listed Hedge Fund Company
A few hedge funds and private equity houses went public in the past few years and it is pretty interesting because you get to invest with some pretty amazing people. 

Some of the private equity shops do look interesting, but I worry that they have gotten so big in the past few years that I wonder how well they will do.  It's one thing to really get huge returns when you only have $2 or $3 billion under management.

If you look at the assets under management of these private equity guys, going over $20 billion (or whatever they are at this point), it gets a lot harder to move the needle in terms of investment performance.  The funds were so huge that only mega-deals made sense for them.  And when you have too many of those guys chasing the few available mega-deals, prices go up and returns go bad.  It also encourages them to move into areas where the capital can be deployed in size…

Back to Och-Ziff
Anyway, here is one interesting hedge fund.  Och-Ziff is a solid hedge fund shop with a pretty good reputation.  Daniel Och, a former Goldman Sachs trader, runs it.  They are very specific in the sort of trades they do and pretty much do strategies similar to what is done on Wall Street investment bank proprietary desks; special situations, arbitrage and things like that.  None of these strategies are going to return 30-40%/year over time, like George Soros.  But they won't really blow up too much either.

Here is the breakdown of strategies in their flagship fund:  These strategies, for the most part, are long/short type strategies and are typically not highly leveraged like fixed income arbitrage funds.  They do sometimes have big drawdowns in stressed periods, but they usually don't blow up like credit arbitrage guys since they don't get 10-1 or 20-1 leverage.

OZM was founded in 1994 by Daniel Och and is still run by him.  He is still 50 years old so we can expect him to continue to run this thing for a while longer; no succession issue here.

OZM IPO'ed back in November 2007, right around at the height of the bubble, or right before things really started to fall apart.  The IPO price was $32/share to the public. 
This is, like other recent hedge fund/private equity IPO's really complex, but to keep it simple, the class A shareholders owns (as of June 2011) 25.6% of the operating business of Och-Ziff.  The class B shareholders own the other 74.4%.  Class B shares are not listed and they are basically Och and his partners.

OK, so let’s look at the actual business.  The hedge fund business makes money by earning

1. Management fees
2. Incentive fees.

Management fees are earned on the assets under management on a fixed basis.  OZM fees average 1.7%.  Incentive fees are earned on the profits they generate.  This is 20%.

As of June 30, 2011, OZM had assets under management of $30 billion or so.   That means that their rate of management fees is $510 million.  Let's assume that over time they can generate 10% returns.  They have done 14%/year over time, but with $30 billion in assets, maybe we should lower that.   If they earn 20% incentive fee on 10% returns, that’s $600 million/year in incentive fees.  Combine those and you get a run rate revenues of $1.1 billion per year.

What about costs?  
The great thing, usually, about asset management firms is that they have a lot of operating leverage; their cost base (other than bonuses) is largely fixed, so any increase in assets either from more fund inflows or good returns (usually both) goes right to the bottom line (after big bonuses, of course).  Some funds have recently learned that this operating leverage works both ways, though.  So we have revenue run rate of $1.1 billion/year.  

What is the expense structure of OZM?  
With 97 million class A shares outstanding at June 30, 2011, that comes to an EPS of $1.02 - $1.16/share.  At the current stock price of $10.74, it is trading at a comparable (to other corporations) P/E ratio of 9.2 - 10.5x.

In more normal times (when strong financials aren't trading at under tangible book value), asset management firms tend to trade at 15-20x P/E.  I wouldn't be surprised to see this get to that valuation either over time.  Maybe once the $1.6 billion/year reorganization cost runs off and the income statement starts to look better (superficially), people will pay more attention to it and maybe it goes up.

Oh yeah, and OZM pays dividends.  Their goal is to pay out all their distributable earnings. Assuming 2010 was not an extraordinary year (they returned 8.5% or so, so nothing special), they will probably be able to pay out $1.00 or more over the next few years.  

That’s close to a 9.3% dividend yield, not bad at all in this environment.  The problem some people may have is that this will come with a K-1 attached since it's a partnership.  If you assume 9.3% dividends is sustainable, and OZM continues to make money for investors and their AUM continues to go up, it's not hard to see a decent return going forward.

Asset management companies generally are good in bull markets due to the operational leverage and things like that, and I do have confidence that OZM will do well over time. I think this is a good, solid firm and Och’s reputation over the years I think has been pretty good.  

However, they are getting pretty big in assets under management and people need to be aware that running a company with $5 billion of AUM is very different than running one with $30 billion.  They may need to find larger and larger deals, ideas and things like that which will lead to lower hurdle rates on investments etc.  If you are too picky with $30 billion, you won't deploy much capital and if you don't, your returns will suffer.

Also, this is a complicated structure with class A shareholders having very little control.  I think Och can do pretty much what he wants to do.  Even if OZM does well, it is possible that class A shareholders don't do well.  Increasing issuance of RSU's to employees will certainly dilute shareholders over time, and of course, class A shareholders have very little say on executive compensation/bonuses which can be very big at these hedge funds.