Fitch Places Och-Ziff (OZM) on Watch for Downgrade
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Fitch Ratings has placed its 'BBB-' Long-Term Issuer Default Rating (IDR) and 'BBB-' senior unsecured debt rating for Och-Ziff Capital Management LLC (NYSE: OZM) and its subsidiaries on Rating Watch Negative.
KEY RATING DRIVERS
IDR AND SENIOR UNSECURED DEBT
The Rating Watch Negative follows yesterday's announcement that OZM has entered into a settlement with the Department of Justice (DOJ) and Securities and Exchange Commission (SEC) regarding violations of the Foreign Corrupt Practices Act (FCPA). The settlement includes a $412 million fine and deferred prosecution agreement for OZM and a guilty plea by one of OZM's subsidiaries, OZ Africa Management GP LLC. OZM's founder, Daniel Och, also agreed to pay a $2.2 million fine related to record-keeping violations, while OZM's CFO, Joel Frank, agreed to pay a yet-to-be-determined fine related to record-keeping violations.
The Rating Watch Negative indicates a heightened probability of potential negative rating action over a shorter period of time relative to the Negative Outlook previously assigned to OZM. While OZM's parent company avoided a guilty plea as part of the settlement, Fitch believes that the guilty plea by its subsidiary, OZ Africa Management GP LLC, and the administrative settlements agreed to by Daniel Och and Joel Frank could potentially contribute to reputational damage for the overall firm and result in near-term assets under management (AUM) outflows. Fitch also notes that OZM may potentially experience increased fee pressure and fundraising challenges as a result of the settlement.
Fitch expects that OZM's elevated legal expenses should begin to normalize, albeit with some lag, following the settlement. However, potential AUM outflows would pressure OZM's management fees and thus its cash flow leverage and interest coverage metrics.
OZM is further challenged by lackluster short-term investment performance, with year-to-date (YTD) returns of 0.36% for OZ Master Fund. The multi-strategy hedge funds represent more than 50% of OZM's total AUM. As of Aug. 31, 2016, OZM's funds experienced $5.5 billion in AUM net outflows, representing a 12.1% decrease since the end of 2015.
The financial settlement and other liquidity needs are expected to be managed via cash on hand ($368.2 million as of second quarter 2016 [2Q16]), retained earnings (as was retained in 1H16) and the previously announced $400 million partner capital contribution in the form of perpetual preferred units. Fitch expects the proceeds of the partner capital contribution to be used, over the near term, to pay down the $120 million draw on the revolving credit facility that was outstanding as of 2Q16. Fitch views the partner capital contribution and the paydown of the revolving credit facility as important mitigants to immediate rating pressure.
OZM's leverage, as calculated by debt/FEBITDA increased to 4.0x for the trailing 12 months (TTM) ending 2Q16 from 2.7x for TTM 1Q16 and 2.3x in 2015. Between 2011 and TTM 3Q15, Fitch-calculated leverage was under 2.0x. Pro forma for the repayment of the revolver and a normalization of non-compensation expenses, Fitch estimates that OZM's leverage would have been 2.8x at 2Q16. That said, material outflows would pressure this ratio.
OZM's interest coverage, as calculated by FEBITDA divided by interest expenses decreased to 6.4x for the TTM ending 2Q16 from 7.8x for TTM 1Q16 and 9.3x in 2015. Between 2011 and TTM 3Q15, Fitch-calculated interest coverage was in excess of 30.0x. 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 8.6x at 2Q16. Material outflows would similarly pressure this ratio.
Fitch would view sustained debt/FEBITDA in excess of 3.5x or interest coverage below 5.0x as negative rating drivers.
OZM's IDR is supported by its long-term performance track record, particularly in the firm's core multi-strategy hedge fund business; acceptable long-run leverage and interest coverage metrics; strong core profitability; and a seasoned management team.
Key rating constraints beyond those articulated in the Negative Watch rationale above 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.
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 six months. More specifically, outflows, fee pressure and/or elevated expenses which translate into sustained leverage above 3.5x, interest coverage below 5.0x 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.
The Negative Watch could be revised to 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 revision of the Negative Watch to 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 below 3.5x and above 5.0x, 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.
OZM is an alternative investment manager with expanding credit and real estate businesses. The firm had $42 billion of AUM with 611 employees in eight offices worldwide as of June 30, 2016.
Fitch has placed the following ratings on Rating Watch Negative:
Och-Ziff Capital Management Group LLC
OZ Management LP
OZ Advisors LP
OZ Advisors II LP
-- Long-term IDRs 'BBB-'.
Och-Ziff Finance Co. LLC
-- Long-term IDR 'BBB-'
-- $400 million senior unsecured debt 'BBB-'.
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