Fitch Affirms Oaktree at 'A'; Outlook Stable

NEW YORK--(BUSINESS WIRE)-- Fitch Ratings has affirmed the Long-Term Issuer Default Ratings (IDRs) of Oaktree Capital Group, LLC and its related entities (collectively Oaktree) at 'A'. The Rating Outlook is Stable. A complete list of ratings is detailed at the end of this release.

Today's rating actions have been taken as part of a periodic peer review of the Alternative Investment Manager (IM) industry, which comprises seven publicly rated global firms. Fitch's outlook for the sector is stable; reflecting the relative stability of core operating fundamentals, given the locked-in nature of a large portion of fee revenue, modest but increased leverage levels, manageable near term obligations relative to available liquidity resources, increasing asset under management (AUM) diversity and investors' increasing allocation to alternative investments, particularly those managed by alternative IMs with strong franchises such as those included in Fitch's peer review.

Fee-earning AUM (FAUM) growth has slowed considerably for the rated peer group, as numerous strategies have record levels of uncalled capital to invest. Fundraising is expected to moderate to some extent, as a result, but management fees are expected to retain their resiliency as capital not-yet-earning management fees (shadow AUM) remains elevated and realizations of legacy investments have declined. While an increase in market dislocations would impact the valuations and realization of existing investments, it could also result in stronger management fee growth, as uncalled capital would be invested at a faster pace. Fitch does not expect a widespread distress cycle to emerge over the near term.

The variable cost structure of the alternative IMs has contributed to relatively steady cash flows through cycles. Fee-related earnings before interest, taxes, depreciation, and amortization (FEBITDA) margins rebounded modestly in 2015 and 2016 as many alternative IMs have begun to realize the scale benefits of follow-on funds and adjacent strategies. The FEBITDA margin for 'A' category alternative IMs averaged 41.6% for the trailing 12 months (TTM) ended Sept. 30, 2016, which compared to a 35.6% average for 2015 and Fitch's quantitative benchmark range of 30%-50% for 'A' category alternative IMs. Still, dispersion in the group is significant, with a more than 25 percentage point differential between the highest and lowest performer, driven by differences in strategy and product mix. Fitch believes higher margins provide enhanced operating flexibility through cycles.

Gross realized incentive income has steadily declined, since peaking in 2014, driven by the length of time valuations have been at elevated levels, a less supportive IPO environment, and a reduction in the average age of fund investments. Exit activity has declined in 2016 and is likely to moderate further, which points to likely reductions in distributable earnings. Incentive income accruals remain strong and Fitch believes realized incentive income may be less volatile than pre-crisis experience given the increased diversity of product platforms.

Leverage levels have increased across the industry, as issuers have taken advantage of the low interest rate environment to issue long duration funding for the purpose of funding balance sheet co-investments, acquisitions, and, in some instances, to pre-fund maturities. Average leverage, defined as debt divided by FEBITDA, was 3.16 times (x) for 'A' category firms for the TTM ending Sept. 30, 2016, which compares to Fitch's quantitative benchmark range of 0.5x-2.5x for 'A' category alternative IMs. Fitch believes the issuances have been largely opportunistic and views the reduction in refinancing risk favorably. Over time, Fitch expects leverage levels to generally decline to the benchmark range, as FEBITDA growth is driven by cost controls, increased scale, continued fundraising, and the gradual deployment of FAUM that earns fees on invested capital.

Counterbalancing the up-tick in leverage is the maintenance of strong liquidity profiles. Several firms remain in a negative net debt position and 2016 saw the introduction of perpetual preferred issuances by two issuers in the sector, with proceeds, to date, used to improve operating flexibility and liquidity. Debt maturities are negligible for the sector in 2016-2018. Payout ratios remain relatively high, but Fitch believes alternative IMs retain the ability to reduce shareholder distributions, as necessary, to meet obligations. While several share repurchase programs were announced over the last 12 months, execution of the programs is expected to remain opportunistic and is not expected to impair the sector's overall liquidity.

KEY RATING DRIVERS

IDRs AND SENIOR DEBT

The rating affirmations for Oaktree reflect its strong position as a global alternative IM, solid investment track record, experienced management team, large base of FAUM, strong blended management fee rate, given the absence of a step-down in the management fee percentage once closed-end funds enter their liquidation period, a lack of reliance on transaction and monitoring fees for revenue, incentive income-generating capability, growing investment income from Oaktree's minority ownership in DoubleLine Capital LP (DoubleLine), solid liquidity, and subordination of general partner interests to outstanding indebtedness.

Rating constraints for the alternative IM space include 'key man' risk, which is institutionalized throughout many limited partnership agreements, reputational risk, which can impact the company's ability to raise future funds, and legal and regulatory risk, which could alter the alternative asset space. Rating constraints more specific to Oaktree include lower relative AUM diversity, higher exposure to net asset value (NAV)-based fees and elevated leverage.

FAUM amounted to $78.7 billion at Sept. 30, 2016, up about 2.9% from the third quarter of 2015 (3Q15), due largely to capital raised in closed-end funds. Open-end fund FAUM declined 4.7% over the TTM as redemptions surpassed contributions and market value appreciation. Closed-end FAUM was up 9.3% year-over-year given increased capital deployed in drawdown funds and the start of several fund investment periods, including Oaktree Opportunities Fund X's in January 2016.

Capital raising has remained solid thus far in 2016, with $9.6 billion raised over the TTM ended Sept. 30, 2016; although this was down from record levels achieved in the prior year due largely to capital committed to the new distressed debt funds. At Sept. 30, 2016, uncalled capital commitments were near a company-record, at $22.7 billion, of which $13.3 billion were not yet generating management fees (shadow AUM). Oaktree Opportunities Fund Xb accounts for nearly $8 billion of shadow AUM and is not expected to begin to generate management fees on committed capital until late 2017.

Oaktree's core operating performance was up in the first nine months of 2016 as management fees rose on higher FAUM and core compensation declined. As a result, the firm's FEBITDA margin improved to 34.2%, which is modestly below the 'A' category peer average but in line with Fitch's quantitative benchmark of 30%-50% for alternative investment managers in the 'A' rating category. Fitch expects relative stability in management fees and FEBITDA over the balance of 2016, but believes both could grow in the latter part of 2017, when the investment period for Oaktree Opportunities Fund Xb is expected to begin.

Incentive income rose 23% in the first three quarters of 2016, compared to the same period in 2015, due largely to strong performance in 3Q16, with distributions from six funds across five investment strategies. Accrued incentives remained solid, at $872.7 million, net of the associated compensation, which points to the potential for meaningful incentive income in the future, but Fitch expects more modest incentive income generation over the near term as only 25.8% of accrued net incentives are associated with funds currently paying incentives.

Oaktree's leverage, as measured by long-term debt divided by FEBITDA, amounted to 2.99x on a TTM basis at Sept. 30, 2016, which is above Fitch's 'A' category benchmark range of 0.5x-2.5x. However, leverage is overstated by $50 million of November 2016 debt maturities which were effectively pre-funded with Oaktree's 2014 senior note issuance. Removing the 2016 maturity from total debt reduces leverage to 2.81x, which is still above the 'A' category benchmark, but below the peer average. Fitch believes leverage will decline closer to the 2.5x level over time as shadow AUM begins to generate management fees.

If Fitch were to include non-performance investment income that Oaktree earns from its investment in DoubleLine, leverage would be approximately 2.29x on a TTM basis, removing the 2016 maturity from total debt. This income stream, which is tied largely to management fees on open-end, NAV-based funds, has increased significantly over time as DoubleLine's FAUM has grown. Fitch will continue to monitor the stability and predictability of this income stream over time, but it has thus far improved and diversified Oaktree's cash flow generation in recent periods.

Fitch believes Oaktree has a solid liquidity profile. At Sept. 30, 2016, Oaktree had $461.4 million of balance sheet cash, $676.2 million of government and time deposit securities, and $500 million of borrowing capacity on its bank revolver. This compares to $50 million of debt maturities in 2016 and $516.6 million of aggregate GP commitments to the funds as of June 30, 2016.

In 2Q14, Oaktree increased its standard payout ratio to 85% from 80% of its distributable earnings, retaining the rest for fund co-investments, possible corporate transactions, and enhanced liquidity. Fitch is comfortable with the updated policy, given the firm's sound liquidity position, but would expect the firm to reduce shareholder distributions should corporate cash demands increase. The payout ratio was approximately 85.2% for the first three quarters of 2016.

The Stable Rating Outlook reflects Fitch's expectations that management fees will increase in 2016-2017 as shadow AUM begins to generate management fees, which will allow for modest margin expansion and balance sheet deleveraging. The Outlook also reflects the agency's belief that Oaktree will grow/retain FAUM through the raising of new and expansion of existing fund strategies and retain a solid liquidity profile in order to fund operations and meet co-investment commitments to the funds.

RATING SENSITIVITIES

IDRs AND SENIOR DEBT

Fitch believes positive rating momentum for Oaktree is limited, given its current rating levels and the nature and risk profile of the business, including the impact that key man events and/or reputational damage can have on the franchise and future fundraising prospects. However, positive momentum could develop over time with a meaningful reduction in key man risk, an increase in fund and fee diversity, enhanced stability of incentive income through a variety of market cycles, stronger funding diversity, and declines in leverage.

Declines in investment performance, a key man event, and/or legislative risk which negatively impact the company's ability to raise FAUM and generate fees, meaningful increases in leverage, and/or impairment of the liquidity profile could result in negative rating action.

Oaktree is a global alternative IM with a focus on credit and contrarian, value-oriented investing. FAUM amounted to $78.7 billion at Sept. 30, 2016 and total AUM was $99.8 billion. The company's Class A units are listed on the NYSE under the ticker 'OAK'.

Fitch has affirmed the following ratings:

Oaktree Capital Group, LLC

Oaktree Capital Group Holdings, L.P.

Oaktree Capital I, L.P.

Oaktree Capital II, L.P.

Oaktree AIF Investments, L.P.

--Long-Term IDR at 'A'.

Oaktree Capital Management, L.P.

--Long-Term IDR at 'A';

--Unsecured debt at 'A'.

The Rating Outlook is Stable.

Additional information is available on www.fitchratings.com

Applicable Criteria

Global Non-Bank Financial Institutions Rating Criteria (pub. 15 Jul 2016)

https://www.fitchratings.com/site/re/884128

Additional Disclosures

Dodd-Frank Rating Information Disclosure Form

https://www.fitchratings.com/creditdesk/press_releases/content/ridf_frame.cfm?pr_id=1014224

Solicitation Status

https://www.fitchratings.com/gws/en/disclosure/solicitation?pr_id=1014224

Endorsement Policy

https://www.fitchratings.com/regulatory

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Source: Fitch Ratings

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