Och-Ziff Capital's (OZM) IDR Rated 'BBB-' by Fitch; Outlook Stable

Fitch Ratings has assigned a Long-Term Issuer Default Rating (IDR) of 'BBB-' to Och-Ziff Capital Management Group LLC (NYSE: OZM). The Rating Outlook is Stable.

KEY RATING DRIVERS

The rating and Stable Outlook are based on OZM's established franchise and performance track record, particularly in the firm's multi-strategy hedge fund business, appropriate leverage and interest coverage metrics, strong profitability and a seasoned management team. Key rating constraints include the elevated level of market risk due to net asset value (NAV)-based management fees, key man risk with the firm's founder and CEO, less diversified (albeit improving) assets under management (AUM) relative to higher-rated peers and potential reputational risks associated with ongoing regulatory investigation.

OZM's funds have demonstrated relatively consistent investment performance, with its flagship strategy reporting only three negative years since inception in 1994. None of OZM's funds have ever imposed gates, which allowed the firm to solidify its reputation and attract significant capital inflows in recent years. Since 2010, the firm has reported net inflows of $12.2 billion supporting growth in overall AUM to $45.9 billion as of June 30, 2014. Despite the significant growth in AUM, OZM has been able to sustain consistent investment performance, as evidenced by strong returns in 2012 and 2013.

More recently, OZM has actively grown its credit and real estate businesses, alongside continued growth in its traditional multi-strategy hedge funds. While the newer products tend to generate lower management fees, they provide increased AUM and fee diversity, which are viewed positively by Fitch. The growth strategy for these businesses has been largely organic, which helps preserve the existing culture and cost discipline. Continued growth, seasoning and consistent performance in credit and real estate, could drive positive rating momentum over time.

Fitch believes OZM's funds maintain a relatively conservative risk profile, which supports management fee stability. For example, fund-level liquidity and funding are carefully managed on a centralized basis, and leverage is utilized sparingly, reducing downside risk. However, many of the funds have key man provisions tied to founder and CEO Daniel Och and other executives, which increases redemption risk. Furthermore, some of the company's more recent credit businesses, such as CLOs, have not yet seasoned and sustainability of their long-term performance remains unproven.

Core operating performance has been strong, driven mainly by management fees, which increased to $314 million in 1H14, up 20.3% from 1H13. The average management fee rate during 2Q'14 was 1.45% of total AUM, compared to 1.53% during 2013 and 1.63% during 2012. The decline was driven primarily by increased AUM from credit funds and CLOs, which generate lower management fees than multi-strategy funds. The firm also generates a substantial amount of incentive income, which is directly tied to the performance of the funds and therefore tends to be more volatile.

The company's fee-related earnings before interest, taxes, depreciation, and amortization (FEBITDA) increased to $204 million in 1H14, up 31.9% from 1H13. The FEBITDA margin has ranged between 35 - 40%, which places OZM close to the top of the alternative asset manager peer group. Fitch believes OZM's attractive financial performance is driven by its steady growth and ability to control expenses. The expansion into credit and real estate has allowed the company to diversify its AUM base, deepen investor relationships and increase the amount of long-term committed capital. However, Fitch believes OZM's profitability remains more susceptible to market risk than more highly-rated alternative asset manager peers, since the majority of OZM's management fees are based on NAV, whereas private equity-oriented alternative asset managers benefit from a greater proportion of fees that are based on committed capital.

In its analysis of OZM, Fitch primarily relies on the company's non-GAAP reporting of economic net income. Fitch takes a corporate approach, in which the focus is on debt service and cash flow coverage rather than balance sheet analysis. Fitch uses 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 partial bonus), excluding incentive income, less operating expenses plus depreciation and amortization.

OZM's credit ratios have improved over the past several years, and compare well to the alternative asset manager peer group. As of June 30, 2014, debt-to-FEBITDA stood at 1.76x (on a TTM basis), compared to 1.92x as of Dec. 31, 2013. Interest coverage (FEBITDA-to-interest expense) was 34.3x for the twelve month ended June 30, 2014, up from 28.6x during full-year 2013. The improvement in both ratios was driven by increasing FEBITDA.

Historically, the company has been able to meet its operating expenses and working capital needs through cash generated from management fees and incentive income. Most of the remaining cash is distributed to shareholders via quarterly dividends. Salaries and bonuses represent by far the largest portion of cash expenses (72% average of the past 5 years). While the bonus payments are discretionary and tend to be tied to incentive income, Fitch believes OZM is likely to pay out some level of cash bonuses even during years in which its funds do not generate any incentive income, in order to retain top talent. Therefore, Fitch deducts a portion of the cash bonus from FEBITDA.

Fitch views the ongoing regulatory investigation into the company's conduct related to the Foreign Corrupt Practices Act as a rating constraint, given the uncertainty surrounding the outcome and the potential reputational impacts it could have. While the disclosure of the investigation has not impacted the company's fund-raising ability to date, Fitch believes an adverse outcome could impact OZM's fund flows, future fundraising and franchise. The company's public disclosures indicate that OZM is not subject to any legal proceedings that it expects would materially impact its financial statements.

RATING SENSITIVITIES

Positive rating drivers could include a continued increase in AUM and fee diversity, particularly towards committed capital structures, seasoning in some of the firm's newer businesses, sustained conservatism in leverage and liquidity levels and resolution of the ongoing regulatory investigation. The ratings could also benefit from a reduction in key man risk, which Fitch considers to be elevated in relation to peers. This could be achieved through broader key man triggers at the fund level and a more diverse voting structure and continued development of the senior leadership group.

Negative rating drivers could include material declines in investment performance, which negatively impact the company's ability to maintain AUM and generate fees, meaningful deterioration in operating margins, leverage or interest coverage metrics and/or a key man event. An adverse outcome of the ongoing regulatory investigation could also result in negative rating pressure.

OZM is a leading alternative asset manager, with expanding credit and real estate businesses. The firm managed $45.9 billion of AUM as of June 30, 2014, with 570 employees in 7 offices worldwide.

Fitch has assigned the following ratings to Och-Ziff Capital Management Group LLC:

--Long-term IDR of 'BBB-'; Rating Outlook Stable.

You May Also Be Interested In

• Amphenol (APH) Tops Q1 EPS by 7c, offers guidance
• Masonite Int'l (DOOR) Sells Architectural Business Segment
• Enterprise Financial Services (EFSC) PT Lowered to $49 at Keefe, Bruyette & Woods