Alternative asset management firms like Oaktree(NYSE: OAK), KKR, and Blackstone(NYSE: BX)are complicated businesses, and individual investors tend to shun their stocks because of it.
In this week's episode of Industry Focus: Financials, host Gaby Lapera is joined by Jordan Wathen to dive into alternative asset management, and what factors individual investors should look at before deciding to buy into one. Find out why these firms' business models are so complicated; what kinds of investors tend to use them to manage their funds; what the best of these firms do differently from the rest; how they are similar to hedge funds -- and how they differ; what their fee structures look like; what investors should watch out for; and more.
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A full transcript follows the video.
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This video was recorded on April 24, 2017.
Gaby Lapera: Hello, everyone!Welcome to Industry Focus, the podcast that dives into a different sector of the stock market every day. You're listening to the Financials edition, taped on Monday, April 24, 2017. My name is Gaby Lapera, and joining me on Skype is Jordan Wathen, an exotic financials expert. Hey, Jordan! How's it going?
Jordan Wathen:Hi, Gaby! I like the intro: an exotic financials expert.
Lapera: I just realized that sounds way more risque than what I actually meant, which is that you know a lot about weird financial businesses, like businesses that have strange structures, and esoteric ways of making money, which is what today's show is about, which is why I introduced you as an exotic financials expert.[laughs]
Anyway, today, we're going to be talking about alternative asset managers. If you're already lost, that's totally OK. We're going to do our best to explain everything, or at least something. Today's question is actually based on some feedback that we got from a listener at the University of Chicago. I forgot to ask his permission to use his name, so we won't, but thank you so much for the great questions. Good luck with your junior year. That's always a long, hard slog.
This is what the listener had to say: "I wanted to hear your thoughts on investing in alternative asset management firms, i.e. Oaktree, KKR, Blackstone. Many have claimed that these firms are trading at a discount for a number of reasons. Theirbusiness models and financial statements are egregiously difficult understand,frustrating many retail and institutional investors. There's a drasticvariability in yearly results. Andprofitability is highly dependent on assets under management." My answer to you is yes, yes, yes, and yes. We'llbacktrack first. Alternative asset managers areconfusing, so let's start at the beginning. What is analternative asset manager? Jordan, to you.
Wathen: Toput it very simply, analternative asset manager is anasset manager thatmanages alternative assets.I guess the more important thing is,what is an alternative asset?The best description is that an alternative asset issomething that the average Joe isn't likely to own aspart of their portfolio. Think things like private equity or venture capital or distressed debt,for example.
Lapera: Italso includes stuff likereal estate, if it's not just your house, orcertain collectible stuff likeartwork, butthat tends to be very exotic.
Wathen: Right,I shouldn't forget aboutartwork. I guess, when you think about alternative assets, there's really two things that sets them apart. Thefirst thing is that they're illiquid: They take time to buy and sell. Thestrategies that these managers usetake time to generate returns. For example,Blackstone might by a private company forone of its funds and then hold that company for seven or 10 yearsbefore it sells that company and distributes the profits to its investors. Adistressed debt fund might buy debtwith the goal of taking control of a company in bankruptcy, which is a long slog, a nasty process, and it takes time togenerate returns that way, too. So, these fundstypically have a lock-up periodin which investors can't access their money for five or even 10 years. Andactually, there's been some effortby the Blackstones of the world toextend this lock up period for as long as 15 or 20 years.
Lapera: That's a long time,especially for your average investor, whichkind of brings me to my next point,which is that generally, it's not your average investor who'sgiving money to these alternative asset managers. It's super-wealthy individuals or families, pension funds, and,am I forgetting someone? I feel like I am.
Wathen: Pension funds,state governments, colleges. The Ivy League schools have $250 billion combinedbetween all of them; they'remajor investors in this kind of world. The bigcommonality with all these investors is they're generally tax-free. The managers who manage this money can invest differentlybecause their investors don't care about whether or not the returns are long-term capital gains or short-term capital gains. Itreally doesn't matter because they're not paying taxes anyway.
Lapera: Yeah. Thenext question would be,how do they make money? As we've answered, it depends on theasset manager, because they might specialize in different things. For example, Blackstone specializes in private equity,but it also does some real estate and hedge-fund solutions.
Wathen: Right. Blackstone is really known for private equity, but their hedge-fund solutions business has grown really big. To define that,it's basically a fund of funds. Someone comes toBlackstone with $1 billion and they say, "Wewant to invest in the world's best hedge funds,help us find them," and then they take a small cut for doing that. So there'sreally a bunch of different ways that they can make money.
And,as we talked about,the big difference with alternative asset managers is the fee structures are different. If welook at the world of mutual funds, acompany likeT. Rowe Price, which managesbillions upon billions of dollars, it manages them in traditional mutual funds, things that you and I might own,not private equity funds or whatever. It earns a simple 1% or 0.8% management fee on the assets it manages, and that's it. Alternative asset managers,on the other hand, their funds are structured sothey get a management fee, plusincentive feeswhen they generate returns in excess of a hurdle rate. The investor might want 8% a year, and beyond that, the fund company, if theygenerate 10% per year, they'll get20% of that upside, of the 2% over 8%.
Lapera: Exactly. Listeners, what you might be hearing is,these asset managers make money intwo different ways. One is through the fees, whichsometimes are dependent on assets under management and a bunch of other things. The other thing that they might make money on is their actual investments. Hopefully, they're investing in such a way that they're actually creating profit. But when you talk about investing in an asset management firm, like I said, you're probably not talking about actually giving your money to the asset management firm; you're talking about buying stock in the asset management firm.
Wathen: Generally, these companies, say, Oaktree Capital Group, for example, they manage something like $100 billion of assets. They also have about $1.5 billion that's invested in their funds. Butfor the most part,the big earnings driver is the feesthey generate on the $100 billion, rather than the $1.5 billionof their own capital that they manage.
Lapera: Yeah,definitely. I think the next question that we want to ask -- togo back to the original question that was asked by the listener -- as you guys have seen, these firmscan be very difficult to understand, because they're investing in a type of asset that is not reallyall that commonplace,so you have to understand a little bit about the assets in order to even decode their balance sheet or income statement. Thesecond part of that question is, there can bedrastic variability in yearly results, and that theprofitability is highly dependent on assets under management. Whenyou're looking at investing in one of these firms, what aresome of the things that you should look for?I think the best way to do this is pick one, since they're allso different from each other, and dig in. We talked about doing Oaktree.
Wathen: Yeah. The important thing thatyou have to remember when you investin the asset management company is that it's really only as good as its funds are. Anasset manager that runs a bad fund won't be in business very long, especially not charging 1.5% on assets, plus 20% incentive fees. The world doesn't want to invest in an underperforming fund that charges an above-average fee. So,one way to get a really good idea ofhow a business like Oaktree is performing is to look at the balance sheet. Look at net accrued incentives. This reflects how much Oaktree willreceive inincentiveincome from its funds -- basically, fees that it earns forgenerating good performance minus any bonus compensation that it owes its employees as a result of those returns. What you'dreally like to see is this net incentive income, or thisaccrued incentive income, increases over the course of time.
Lapera: Is there ever [a case of] "This has increased too much?"
Wathen: No, there's no such thing as that numberincreasing too much. Ifanything, that would mark something like a cyclical peak. So, if, let's say tomorrow, the debt markets fall out, Oaktree is going to raise tens of billions of dollars and put it to workalmost immediately, andwithin the next couple years, as the economy recovers,you would see that incentive income come up. Then, over time, as those funds are liquidated, they would pay off theirinvestors, and the money would come back to them for generating those superior returns. If anything, you have ebbs and flows in it, but no, there's no suchthing as too much.
Lapera: That'sactually a really good point that you just made. It's a very cyclical business,much like the financial markets at large. But the interesting thing about alternativeasset managers is that they often tend to do well when the market is doing poorly, because they act as hedge funds.
Wathen: Right. Oaktreehas a reputation for being the company thatdoesn't want to attract assets just to attract assets. If Oaktree gives you a call and says, "We're raising a new distressed debt fund," it'sbecause they see opportunities,or they see a world in which they will haveopportunities in the next few years. Because of that, they'reone of the few asset managers that even runs $100 billion or more. But, they'repart of that select group that can really make a phone call and raise $10 billion overnight. I mean thatalmost literally, because they earned thatcredibility with investors, andbecause their returns have been so good over time.
Lapera: Yeah.I think the other thing to look at when you are investing in alternative asset managers is who the management is,because that can make a huge difference. In Oaktree,it's definitely noticeable.
Wathen: Right. They have thiscompany culture that the investor comes first, and the shareholders will be taken care of before that. Actually, if you look at Oaktree's balance sheet, you'll see it has about $6 a share in net accrued incentives that it's earned from these funds, because it calls money when itactually sees good opportunities,not just because it wants to raise a fund and charge more management fees. It'sjust not that kind of business.
Lapera: Yeah. And for that,you really have to trust that the management knows what it's doing. If you don't trust the management of an alternative asset manager, don't invest in them. It doesn't matter how lucrative it looks, just don't do it, because you fundamentally disagree with how it's being run.
Wathen: I completely agree with that.
Lapera: We talked a little bit about what alternative asset managers are, how they make money, different revenue streams,things that should look good on their income sheet,income statement, balance sheet, 10-K, 10-Q, financialstatements in general. Is there anything you would look at and be like, "This is a huge red flag for an asset manager"?
Wathen: I think thisextends across any business, financial or otherwise: Truly great businesses havepricing power. That means they can raise prices, or at least control prices, to some extent. For example,if Warren Buffett tomorrow stepped down fromBerkshire Hathawayand said, "I'm going to raise a $5 billion stock fund and become a hedge fund manager again," he would have no problem findinginvestors at 2% and 20%, thetypical fee structure. I bet he would even have a line out the door at 3% and 30%. There's actuallya company by the name ofRenaissance Technologies, it runssomething called The Medallion Fund. It's the most legendary hedge fund of all time: It charges 5% on assets, plus 44% of returns. The fees are ridiculous, but the returns are so good, no one cares. If you earn 20% after fees,you don't care what the fees are, it just doesn't matter. So, whileinvestment fees are generally coming down, goodasset managers should be able to hold the line, or at least slow the ...
Lapera: The free fall?
Wathen: ... the trend toward lower fees.
Lapera: Yeah. Andpart of the reason for that trend toward lower fees is actually in an alternative assetmanagement adjacent field, which is the ETFs and the mutual funds and the index funds. You're seeing fees go down really fast in those areas because of theautomatically generated nature of these. Companies likeVanguardare pushing for lower fees,because it doesn't make sense in a lot of cases for anS&P 500 ETF, for example, to have a 1% management fee. That doesn't make sense. You'rejust taking all the companiesthat are in the S&P 500 -- you're not guessing or anything -- and putting them into an index fund. So, I think you're seeing this widespread fee lowering. The other thing is the power of information. Now thatconsumers have the internet, they can just go and see what the fees are on other funds, and be like, "You know, I'mnot going to pay 1% when I could pay 0.05% for this other fund."
Wathen: It'sthe exact same thing that's going on in traditional asset managers. If a mutual fund manager could promise me they were going to beat the S&P 500 by 2% a year, I'd happily pay 1.75% a year in expenses andtake the 0.25% extra return. No one isgoing to complain about that. But if the returns aren't there and you're charging a higher fee, you won't be in business very long. And ETFs, and all these passive funds, for that matter, are really justtaking more and more share for that reason.
Lapera: Yeah,which is why I, as we circle back toalternative asset managers, they are able to charge higher fees -- because in theory, they're making more than the return on theS&P 500.
Wathen: Right, they'regenerating superior returns, and they're alsoworking harder for it. Oaktree, when it takes a distressed debt fund andstarts raising money for it and then starts investing in it, they'regoing to have to go through bankruptcy courts, all this stuff,to take control ofthese companies. It's a long slog. It takes money and capital and geniuses tofigure out these opportunities. So,that's what you're paying for, in theory.
Lapera:Yeah. OK. I think, we set out to cover a bunch of things,and I think we've covered them. Listeners, if I'm wrong,go ahead and write me an email at email@example.com, and I'mhappy to talk about this again. This is probably a topic that can spanmultiple episodes,but I promise to give you guys a break in between them. So, forpeople who don't like alternative asset managers -- I don't even know if you're still listening. If you're not, know you have a choice not to listen to the podcast if it's aboutsomething boring. I had someone write to me the other day, and they were like, "Why do you cover such boring things sometimes?" I'm like, "Why do you listen to the podcast if you think it's boring? Just skip that episode, go to the next one!"[laughs]
Wathen: Right. It'shard to make financial stocks truly something that looks great. People aren't drawn to them by nature.
Lapera: Yeah. I mean,I think we're fascinating.[laughs]
Wathen: Of course! I'm not biased or anything, but I would say so too.
Lapera: OK, so,question for you, Jordan. Would youinvest in an alternative asset manager? Would you buy stock?
Wathen: Yes. Butthat comes with a very big caveat that I wouldn't invest in most of them. One of theproblems with financial companies in general -- andthis extends from banking to asset management toalternative asset management -- is that so many of them are actually run to maximizecompensation for employees, rather than profits for shareholders. Theshareholders are at the bottom, taking what's left over after everyone has taken their $2 million bonus. As anexception to that rule, the one that I'm mostinterested in, and I'm glad we talked about it today, was Oaktree.I generally like itas a business model. It's one of the few financial companies that gets better as the world gets worse,which is a nice diversification thing. Earlier this year, Iput together a model for it,and I updated it prior to the show, valuing it in two pieces: the assets it owns and the business as it stands. I value it at about $53 per share, andI think that's kind of conservative. And it's a stock that, if ittraded a little bit lower -- I had to make a lot of assumptions to get to that valuation -- butif it traded a little bit lower, I would be interested in it.
Lapera: Yeah. I actually also really like Oaktree,especially because the investor letters that they share are always really interesting; a lot of really interesting investment knowledge in there. Iencourage listeners to go ahead and read those, they're apretty valuable resource. As for me, if I wouldinvest in alternative asset managers -- they'recurrently not for me right now,mostly because I have no money, soI can't actually invest in anything right now, not until I have a little bit more money. Buteven if I did have money, I think I'm more interested in other types of stocks right now. But I wouldn't rule it out as a future investment.
Wathen: I think timing is important, too. A company like Blackstone, whichmakes a lot of money from private equity, itsbusiness gets better as the world gets better and the economy improves. This late in an economic cycle,I don't know if you want to hold a cyclical company like that, if you want to be the buyer right now this late. With Oaktree,it's the opposite. They get better as distressed debt opportunities come up. So,that would be a company that would get better as things get worse, so it'smaybe more attractive this late in the cycle thansomething like a private-equity company, for example.
Lapera: Yeah. AndI know we're going to get an email now saying, "I thought The Fool said not to time the market." That's true. Youshouldn't time the market. But it's one thing to be like, "I'm going to time the market and do all thistechnical analysis," andit's another thing to be like, "I think this cycle is about probably about here, andreasonablyI can assume that this is what the business will do if it goes this way or that." And if you're wrong, you can always just buy,if you really believe in the company. Just buy it. Dollar-cost average it.
Wathen: It'snot even really so much timing the market. It's like, if I ownBank of America,I know that when the economy gets worse, whenunemployment goes up and GDP drops for a few quarters or a year, their loan performance is going to be bad. It's just going to. They'll havemore defaults and more loan losses. Oaktree,for example: It's a company where it's going to make more money as things get worse. That's where it really shines. So it's diversification, if anything. Instead of buying, maybe, banks, I want to own alittle bit more of this alternative asset manager.
Lapera: Yeah. So,think about it for you. Think aboutwhich one you want to do. Do a lot of research tofigure out what the company actually invests in, andif it's a good idea, andwhat part of the cycle that benefits from, and what the fee structures look like -- basically everything we talked about in this episode,I'm not going to say it all over againbecause we're running out of time.
As usual,people on the program may have interestsin the stocks they talk about, and The Motley Fool may haverecommendations for or against, so don't buy or sell stocks basedsolely on what you hear. Thank you very much for joining us, Jordan!
Wathen: It was fun, Gaby. I always enjoy it!
Lapera: I know. AndI always really like it when we do these weird ones,because I know that's right up your weird alley.
Wathen: I get sucked in by complexity. It's a disease, really, but it makes it more fun.
Lapera: I think it's wonderful. Anyway, contact us at firstname.lastname@example.org, or by tweeting us @MFIndustryFocus and let us knowwhat you'd like to hear about next. We obviously did the show based on a listener question. We are always open for business on that front. Thank you toAustin Morgan,I hope we didn't render you unconscious with that discussion about alternative asset managers.Austin is today's producer. And thank you to you all for joining us. Everyone, have a great week!
Gaby Lapera has no position in any stocks mentioned. Jordan Wathen has no position in any stocks mentioned. The Motley Fool owns shares of and recommends Berkshire Hathaway (B shares). The Motley Fool recommends Oaktree Capital. The Motley Fool has a disclosure policy.