Brookfield Oaktree Holdings, LLC annual report, FY2014

Business context and reporting period

Oaktree Capital Group, LLC’s Form 10-K covers the fiscal year ended December 31, 2014; it is an annual filing, not a quarterly report. The filing describes a global alternative investment manager with $90.8 billion of AUM across credit, distressed debt, control investing, real estate and other strategies. The supplied metadata names Brookfield Oaktree Holdings, LLC, but the filing itself identifies Oaktree Capital Group, LLC as the registrant.

Oaktree consolidates many funds it manages despite holding minority economic interests. Accordingly, consolidated assets, revenues, earnings and cash flows include substantial fund activity attributable to outside investors; management’s segment measures are often more informative about Oaktree’s operating business.

Key financial metrics

Oaktree reported $3.27 billion of segment assets and $1.55 billion of segment liabilities at year-end. Consolidated debt obligations were $7.16 billion, including $850 million of Oaktree corporate debt and substantial nonrecourse debt of consolidated funds and CLOs; these amounts should not be treated as equivalent measures of parent-company leverage. The company reported compliance with applicable debt covenants.

Material changes versus the prior comparable period

• AUM rose by $7.2 billion, reflecting capital raised and leverage, open-end fund net inflows, market appreciation and the Highstar acquisition, partly offset by closed-end fund distributions and foreign-exchange effects. Gross capital raised was $14.7 billion, Oaktree’s second-highest annual total.
• Management fees increased modestly, with growth in open-end and evergreen strategies offset by lower closed-end fees, including fewer prior-year deferred and retroactive fees.
• Incentive income declined sharply as distributions from funds, particularly Opps VIIb, fell. Closed-end fund distributions decreased to $7.0 billion from $12.0 billion in 2013. Investment income also fell, including a reversal from a 2013 market-value gain to a 2014 loss on Cinda.
• Fee-related earnings decreased to $253.1 million from $260.1 million, while fee-related earnings attributable to Oaktree increased to $61.3 million from $50.1 million. Oaktree cited higher compensation, including equity-based compensation, and growth-related costs.
• Closed-end funds’ aggregate gross return was 9.0% in 2014, below the 19.6% since-inception gross IRR reported for incentive-creating closed-end funds. Distressed Debt funds returned 1% in 2014, versus 24% in 2013; Real Estate and European Principal Investing had stronger reported returns.

Outlook, commentary, risks and unusual items

• Management said that, based on year-end accrued incentives, near-term incentive income was not expected to increase above its 2014 level. Of approximately $1.0 billion of net accrued fund-level incentives, $420.7 million related to funds then paying incentives; timing and realization remain uncertain.
• Management identified real estate, Europe, energy, shipping and infrastructure as areas offering investment opportunities. It continued marketing several closed-end funds and highlighted newer strategies as contributors to fundraising. No quantified earnings or revenue guidance was provided.
• Market commentary cited uneven global growth, falling oil prices, weaker high-yield and emerging-market performance, delayed U.S. rate increases and currency volatility. Principal business risks include volatile incentive and investment income, fundraising and redemption uncertainty, competition, key-person dependence, illiquid and difficult-to-value investments, leverage and counterparty exposure, regulatory change, conflicts of interest, and tax and distribution uncertainty.
• Highstar was acquired in August 2014 for $31.4 million in cash, 100,595 OCGH units and contingent consideration of up to $60 million; the recorded contingent-consideration liability was $27.2 million at year-end. Oaktree also launched CLO products and new strategies, and began advising its first directly advised mutual funds in December.
• Other notable items included $3.0 million of debt-issuance-cost write-offs from refinancing, a $2.1 million loss on sale of properties received in a prior arbitration award, and tax benefits associated with tax-audit resolution and expired statutes of limitations. A previously disclosed lawsuit seeking damages exceeding $800 million was dismissed with prejudice in July 2014. The filing states there were no pending legal actions expected to have a material impact.
• Oaktree’s $1.95 billion of accrued incentives at fund level is a potential, not guaranteed, source of future income. Consolidated funds held $26.3 billion of Level III investments within $46.5 billion of investments, making valuation judgments material. A 10% decline in portfolio values was estimated to reduce segment investment income by $269.6 million for 2014 under the filing’s sensitivity analysis.
• The board declared $3.15 of distributions per Class A unit for 2014; distributions paid during calendar 2014 were $2.71 per unit, with the fourth-quarter $0.56 payment made in February 2015. Distributions are discretionary. Estimated future reductions related to the tax receivable agreement were $295.1 million in aggregate, including $16.7 million estimated for fiscal 2015.

The auditor gave an unqualified opinion on the financial statements and internal control over financial reporting; management also concluded controls were effective. The filing provides no formal quantitative earnings guidance.

Important facts for investors to verify

• Reconcile segment ANI, DE and fee-related earnings with GAAP net income and cash flow, accounting for fund consolidation and non-controlling interests.
• Assess the quality, timing and sensitivity of accrued incentives, particularly the portion not yet eligible for payment and the substantial Level III valuation exposure.
• Review corporate debt maturities, the $500 million undrawn revolver, covenant headroom, fund-level nonrecourse borrowing and capital commitments.
• Track fundraising, fee-generating AUM, fund distributions and redemptions, and whether lower incentive income persists as legacy funds liquidate.
• Evaluate distribution sustainability, tax-receivable-agreement payments, potential unit dilution from OCGH exchanges and equity awards, and the governance implications of executive voting control.