Fitch Cuts Och-Ziff Capital Management (OZM) Ratings to Junk
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Fitch Ratings has downgraded the Long-term Issuer Default Ratings (IDRs) of Och-Ziff Capital Management Group LLC and its related entities (NYSE: OZM) to 'BB+' from 'BBB-'following the company's release of its 3Q16 earnings and asset flow information yesterday. The ratings remain on Rating Watch Negative. A full list of rating follows at the end of this release.
KEY RATING DRIVERS
IDR AND SENIOR UNSECURED DEBT
The downgrades reflect Fitch's expectation of significantly lower future earnings generation capacity following the announced management fee concessions that OZM has agreed to beginning in the fourth quarter of 2016. The decline in the average fee rate to 1.01% from 1.23% in 3Q16 will adversely impact earnings and push financial metrics beyond levels commensurate with an investment grade rating. OZM noted that it has begun to pursue expense reductions, in terms of both compensation and non-compensation expenses, that may counter the revenue declines to some extent. However, the degree of expense offset is uncertain at this time, aside from OZM's indication that in 2017 base salaries and benefits will range between $95 million and $105 million and non-compensation expenses, including interest expense, will range between $151 million and $166 million.
The maintenance of the Negative Watch continues to reflect the heightened probability of potential further negative rating action in the near term if AUM outflows accelerate following the announcement of OZM's settlement with the Department of Justice and Securities and Exchange Commission regarding violations of the Foreign Corrupt Practices Act (FCPA) on Sept. 29, 2016.
While OZM's parent company avoided a guilty plea as part of the FCPA settlement, Fitch believes that the guilty plea by its subsidiary, OZ Africa Management GP LLC, and the administrative settlements agreed to by CEO Daniel Och and CFO Joel Frank could potentially contribute to reputational damage for the overall firm and result in near-term assets under management (AUM) outflows. OZM's 3Q16 asset flows did not indicate material asset outflows thus far, although given the redemption terms of OZM's funds, Fitch expects it to be at least several more months until the full extent of investors' reaction to the FCPA settlement can be fully assessed.
Ratings remain supported by the company's long-term performance track record, particularly in its core multi-strategy hedge fund business; acceptable long-run leverage and interest coverage metrics; acceptable core profitability; and a seasoned management team.
Fitch also views the $400 million partner capital contribution in the form of preferred securities and the expected paydown of the revolving credit facility as important mitigants. Per Fitch's 'Criteria for Rating Non-Financial Corporates', dated Sept. 27, 2016, the partner capital contribution is treated as a shareholder loan. This reflects the strong alignment of interests between the preferred unitholders and common shareholders given significant cross ownership and the limited likelihood that preferred unitholders would exercise the available contractual rights and remedies to the detriment of common shareholders or the institution more broadly. As such, Fitch does not treat the preferred securities as debt obligations of OZM.
Key rating constraints beyond those articulated in the context of the rating downgrade and Negative Watch include the elevated level of market risk due to the meaningful amount of net asset value-based management fees; key man risk associated with the firm's founder and CEO, Daniel Och; and less diversified, albeit improving, AUM relative to higher-rated alternative investment manager peers. Fitch also notes that reduced investor appetite for hedge funds as an asset class, combined with challenged performance relative to benchmarks, has pressured fund flows and fees for the hedge fund industry as a whole.
OZM has historically demonstrated relatively consistent long-term investment performance, with its multi-strategy platform reporting only three negative years since inception in 1994, while generating an 11.8& net return over this time period. However, OZM has been challenged by lackluster short-term investment performance, with year-to-date (YTD) net returns through Oct. 31, 2016 of 1.7% for the OZ Master Fund. The multi-strategy hedge funds represent more than 50% of OZM's total AUM. As of Nov. 1, 2016, OZM's funds experienced $9.2 billion in AUM net outflows, representing a 20.1% decrease since the end of 2015.
Nevertheless, OZM remains one of the largest hedge fund managers in the world, with significant growth and diversification of its AUM post-crisis. OZM has actively grown its credit and real estate businesses, which have served to partially offset performance declines and outflows in the multi-strategy platform. While the newer products tend to generate lower management fees, they provide increased AUM and fee diversity, which is viewed positively by Fitch.
The expansion into credit and real estate has also allowed the company to increase the amount of longer-term committed capital (defined as AUM with initial commitment periods of three years or more) to 41.8% of AUM at 3Q16. Despite the continued increase in longer-term AUM, Fitch believes OZM's profitability remains more susceptible to market risk than more highly-rated alternative investment manager peers, since the majority of OZM's management fees are based on NAV, whereas private equity-oriented alternative investment managers benefit from a greater proportion of fees that are based on committed capital. OZM does not publicly disclose an exact amount of AUM against which fees are assessed on the basis of NAV, but the company's filings indicate that their multi-strategy funds and opportunistic credit funds are 'generally' based on NAV. Together these two represented 73% of AUM at 3Q16.
Core operating performance has weakened over the last year, driven mainly by elevated legal expenses related to the FCPA settlement and a decline in management fees. OZM's management fees decreased to $546.1 million for the trailing-12-months (TTM) ending 3Q16, down from $660.3 million for TTM 3Q15. The average management fee rate for 3Q16 was 1.23% of total AUM, compared to 1.39% at YE2015 and 1.46% at YE2014. The decline had historically been driven primarily by increased AUM from collateralized loan obligations (CLOs) and credit and real estate funds, which generate lower management fees than multi-strategy funds. Going forward, however, fee concessions in response to OZM-specific and industrywide challenges, together with net outflows from the company's multi-strategy funds are expected to be the primary drivers of the lower average fee rate.
In its analysis of OZM, Fitch primarily relies on the company's non-GAAP reporting of economic income. Fitch takes a corporate approach, in which the focus is on debt service coverage and cash flow leverage rather than a balance sheet analysis. Fitch uses fee-related earnings before interest, taxes, depreciation, and amortization (FEBITDA) as a proxy for cash flow in its review of OZM's debt service, which consists of management fees, less compensation expenses (including salary and bonuses equal to 25% of management fees), excluding incentive income, less operating expenses plus depreciation and amortization.
The company's FEBITDA, as calculated by Fitch, declined to $126.9 million for TTM 3Q16, down 45.8% from TTM 3Q15. The Fitch-calculated FEBITDA margin at TTM 3Q16 was 23.2%, which is well-below OZM's historical range of 35% to 45%. The 3Q16 FEBITDA margin was at the low end of Fitch's quantitative earnings benchmark of 20% to 30% for hedge fund managers in the 'BBB' rating category; however, Fitch expects the announced fee concessions to further pressure margins.
OZM's leverage, as calculated by debt/FEBTIDA increased to 4.5x for TTM 3Q16 from 2.3x at YE 2015 and 1.9x at TTM 3Q15. Pro forma for the repayment of the $120 million outstanding under the revolver and a normalization of non-compensation expenses, Fitch estimates that leverage would have been 2.9x at TTM 3Q16, consistent with of Fitch's quantitative leverage benchmark of 1.5x to 3.0x for hedge fund managers in the 'BBB' rating category. However, Fitch expects the announced fee concessions to further pressure cash flow leverage.
Fitch-calculated FEBITDA/interest expense was 5.6x at TTM 3Q16, down from 9.3x at YE2015 and 12.2x at TTM 3Q15. Pro forma for the repayment of the revolver and a normalization of non-compensation expenses, Fitch estimates that OZM's interest coverage would have been 7.9x at 3Q16, consistent with Fitch's quantitative coverage benchmark of 6.0x to 12.0x for hedge fund managers in the 'BBB' rating category. However, Fitch expects the announced fee concessions to further pressure interest coverage.
OZM is a publicly traded holding company, and its primary assets are ownership interests in the operating group entities (OZ Management LP, OZ Advisors LP and OZ Advisors II LP), which earn management and incentive fees and are indirectly held through two intermediate holding companies. OZM conducts substantially all of its business through the operating group entities.
Och-Ziff Finance Co. LLC serves as the debt issuing entity for OZM's unsecured debt issuance, and benefits from joint and several guarantees from the management and incentive fee-generating operating group entities. Fitch's analysis of the unsecured debt relies on the joint and several guarantees provided by the operating group entities.
The IDRs assigned to OZ Management LP, OZ Advisors LP, and OZ Advisors II LP are equalized with the ratings assigned to OZM, reflecting the joint and several guarantees among the entities.
The senior unsecured debt is equalized with OZM's IDR reflecting the expectation of average recovery prospects for the instrument.
IDR AND SENIOR UNSECURED DEBT
Ratings could be downgraded by one or more notches if the settlement and/or investment underperformance result in material AUM outflows over the next three to six months. More specifically, outflows, fee pressure and/or an inability to meaningfully reduce expenses which translate into sustained leverage at or above 4.0x, interest coverage at or below 4.5x or materially reduced liquidity resources would contribute to negative rating action. Ratings may also be downgraded if fundraising capability is materially impaired or Fitch believes the franchise has experienced permanent reputational damage. OZM's ratings also continue to remain sensitive to a key man event with respect to Daniel Och.
Fitch could remove the ratings from Negative Watch and assign a Negative Outlook if the financial impacts, AUM outflows, fundraising capabilities, and/or franchise damage are deemed to be manageable in the context of OZM's financial profile. A stabilization of OZM's investment performance would also contribute to a removal of the Negative Watch and assignment of a Negative Outlook.
Thereafter, a revision of the Rating Outlook to Stable would be conditioned upon OZM's ability to stabilize (or grow) its AUM, demonstrate stronger investment performance and fee generation, normalize its expense base, and return leverage and interest coverage levels on a sustained basis to below 4.0x and above 4.5x, respectively.
The senior unsecured debt rating is equalized with OZM's IDR and, therefore, would be expected to move in tandem with any changes to OZM's IDR. Were OZM to incur material secured debt, this could result in the unsecured debt being rated below OZM's IDR.
Ratings are also sensitive to a change in the ownership of the preferred securities or a material reduction in common stock ownership by the preferred unitholders, either of which would eliminate the current alignment of interests between the investor classes. Under such a scenario, Fitch would treat the full notional amount of the preferred securities as debt, reflecting the cumulative nature of the instrument's dividends and the instrument's change of control provisions, interest rate step-ups and mandatory redemption terms. Such treatment, which would be consistent with Fitch's 'Treatment and Notching of Hybrids in Non-Financial Corporate and REIT Credit Analysis' dated February 2016, would likely have a material adverse impact on OZM's leverage and ratings.
OZM is an alternative investment manager with expanding credit and real estate businesses. The firm had $39 billion of AUM with 548 employees in eight offices worldwide as of Sept. 30, 2016.
Fitch has downgraded the following ratings:
Och-Ziff Capital Management Group LLC
OZ Management LP
OZ Advisors LP
OZ Advisors II LP
--Long-term IDRs to 'BB+' from 'BBB-'.
Och-Ziff Finance Co. LLC
--Long-term IDR to 'BB+' from 'BBB-';
--$400 million senior unsecured debt to 'BB+' from 'BBB-'.
The ratings above remain on Negative Watch.
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