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Howard Marks & Rajath Shourie on distressed cycle, opportunities, liquidity, Oaktree, and career

 

CAIA Australia Event: Howard Marks and Rajath Shourie (November 10, 2016)

Distressed cycle and opportunities today

  • Very little distressed today. Little in the last year or so in oil & gas and mining & metals. 7th year of below average defaults among high yield bonds, so we have to wait
  • People start to talk about a virtuous cycle and when they do that, they usually get into trouble
  • During the commodity downturn, bought some pipeline bonds in the oil and gas sector; love buying things when baby is thrown out with the bathwater and there isn’t a fundamental reason for distress
  • What remains is some oil & gas-related opportunities, asset sales by European banks, and private credit-type of opportunities

Tradeoff between biding time and putting capital to work

  • The most important thing is that we don’t have a trading mentality; we have a value mentality
  • If we buy things for less than their worth, that will do it
  • To be a good investor and to run a good investment business, you have to be very mature
  • The way we do it in practice is we manage capital with drawdown funds
  • Hedge fund structure in distressed debt is a very hard way to run a distressed business. If you are fully invested, when the downturn comes you are going to be carried out
  • When we were raising our big fund in advance of 08, got a lot of questions about competition from hedge funds. What ended up happening was those hedge funds ended up being sources of supply for us. When the downturn came, they could not hold onto the capital and they needed to sell the paper when they got withdrawal notice

How do you think about liquidity in the market place and in within your funds?

  • Best defense against illiquidity is to not need liquidity. When people get desperate for liquidity and they say “I want out at any price”, we can be a supplier of liquidity because we have funds we can call on and that is a great position to be in
  • Reduction of liquidity is a positive for our business. It means there is more fluctuation in market prices as a result of flows in and out of high yield mutual funds or ETF’s

Oaktree and your journey

  • What sets us apart besides excellent people and high skill level is our philosophy which is highly enunciated and very explicit and uniform across the firm in all the things we do. It stresses risk control, consistency, being active only in less efficient markets, high degree of specialization, non-reliance on macro forecasts, and non-reliance on market timing
  • Things we do come under the heading of alternative investing in the sense that they are not traditional stocks and bonds and that happened to be the right place at the right time
  • It is what I would call demographic luck. I didn’t do anything to get into the high yield bond business. My boss at Citibank called me in the summer of 78 and there is somebody named Milken out in California and he deals in something called high yield bonds. Can you figure out what that is? The only thing I did was I was smart enough to say yes

Maintaining returns going forward given inflow of funds?

  • We are in a low-return world and maintaining historical return is tough
  • When looking at track records that are particularly long, I try to decompose how much of that comes from funds that were raised in the 80s and early 90s where it was an easier time to get returns – markets were much less efficient, less competition in some of these areas
  • It’s a constant struggle and we try to make sure that when the time is right for our strategies, we have the capital and we try to make sure we stay out of trouble during the other times
  • If what we own appreciated 75%, that means the market appreciated greatly and means the right amount of capital is less, not more. Being mature in that sense is what wins you respect and it is a virtuous circle in itself. It starts with the manager resisting the temptation to raise all the money he can

Career advice for those starting out today?

  • Great thing about the investment business is that it involves interesting puzzles which are rarely the same twice and a lot of deep thinking. It’s very important for anybody who is starting off in anything to do something that they really like and they are really attracted to and hopefully they are reasonably good at

Full paraphrased transcript below:

Moderator: What do you think about distressed cycle and where the opportunities are today?

Howard: I just think there is very little distressed today. What little there has been in the last year or so has been in oil and gas and mining and metals. We’ve made some good investments but we can’t fill up the portfolio with those two sectors. This is the 7th year of below average defaults among high yield bonds so we have to wait. The way we review the process is that in times when investors are eager to put money to work, Wall Street piles the logs in the fireplace by issuing securities that are weak and shouldn’t have been issued and eventually some economic remiss or something else puts a match to that fuel – then we have a bonfire from which distressed investor finds opportunity. We believe that logs are being stacked and have been stacked for several years now. But nobody can imagine what might cause us to experience economic weakness. At lunch today, my seatmate proposed that maybe we will have 10 years without a recession starting today which will bring the total to 17 or 18. I said I would take the under on that. We get into these times like today when everyone is like central bank is going to keep stimulating, the economy hasn’t had a boom or bust, and I don’t see a reason why things should stop working ever. People start to talk about a virtuous circle and when they do that, they usually get into trouble.

Rajath: I think we had what I will call a mini-panic earlier in the year. It was mostly caused by the commodity cycle and the root cause of that was fear of China slowdown. As fear of China slowdown abated, everything came roaring back. During the mini-panic, of course there were nice distressed opportunities in the commodity areas but they did spread out albeit very briefly into a whole bunch of other sectors including things that were not related to commodities, China, and oil and gas. Example would be telecom – ended up being a reasonably large sector at the beginning of the year. Why would that be? When people have trouble, troubles coming through because of the oil patch, they face redemptions and they have to sell. And they sell what they can sell. They couldn’t sell the oil and gas stuff – they were already very depressed. They could sell the telecom bonds. Within the oil and gas sector, they could sell the pipeline bonds which were considerably in better shape than the bonds issued by oil and gas producers. And of course, we love to buy that stuff. We love to buy things when baby has been thrown out with the bathwater and there isn’t much of a fundamental reason for distress. Now all of that stuff has come back. Those opportunities were quite pleasing and they are gone. What remains is some oil and gas-related opportunities, continued sale of assets out of European banks, and private credit-type of opportunities – which are on the cusp of stress and distress. So those are things we are looking at and we are going to wait until the real next opportunity comes.

Moderator: Tradeoff between biding time and trying to put your capital to work. How do you think about that tradeoff particularly in an environment like this where something that might seem expensive or at least not cheap still tends to rise in prices?

Howard: The most important thing is we don’t have a trading mentality. We have a value mentality. We try to buy figure out the value and buy it for less. If we buy things for less than their worth, that will do it. We don’t buy to keep busy or for the purpose of putting to work. To be a good investor and to run a good investment business, you have to be very mature. There was a youtube about a psychological experiment that was conducted where they had a room with a little table and a chair and a 4-year old kid and a plate and a marshmallow. The guy says to the kid, “I am going to leave the room now and when I come back, if that marshmallow is still there, I am going to put down a second marshmallow.” 80% of the kids ate the marshmallow right away and 20% of the kids did not eat the marshmallow and when the guy came back, they got another marshmallow. By the way, they tracked those kids and the ones who did not eat the marshmallow did much better in life. They tracked them for 40 years. I go through this exercise to tell you that you have to be, in order to do well, delay gratification. To say “you know what, if we put this fund to work now, we can raise another fund and maybe a bigger fund. Then we will have more fees and have more potential upside. But you have to be an adult and you have to say “there are not great investments now. We are not going to put it to work now and we are going to wait.” Waiting is an extremely important part of investing as Buffett would tell you.  

Rajath: On the distressed debt side, the way we do that in practice is we manage capital with drawdown funds. It’s a critical advantage that we have that we have clients that are willing to address capital to us for long periods of time over a 10-year period without any liquidity and with the ability for us to call it down when it’s needed. I think it’s the advantage we have – a lot of people we compete with have a hedge fund type structure. In the hedge fund type structure in distressed debt, it is a very hard way to run a distressed business. If you are fully invested in distressed debt, when the downturn comes you are going to be carried out.

Howard: So Raj, why would somebody have 1-year money if they can get 10-year money? What are the attractions of being a hedge fund rather than private equity structure?

Rajath: What are the attractions? Main attraction in a hedge fund structure is at the end of the year, you get to mark your portfolio and you get to take 20% profit. You get to take 20% profit based on the mark and you don’t actually have to realize the investments. As an economic model, in the short-run, it’s completely superior. But in the long-run, if you are going to get carried out when the next downturn comes and when the next buying opportunity comes, it’s not really a long-term superior model in my view.

Howard: The other thing of course is that we have an 8% hurdle rate. And hedge funds don’t have a hurdle rate. So they get carry every year without having to clear a hurdle which again, frontloads the compensation. But believe me, there is nothing like having capital that you can be sure of a) being able to call and b) not having to pay out for 10 years when the crises come.

Rajath: When we were raising our big fund in advance of 08, obviously we got a lot of questions about competition from hedge funds that are coming into our space. We ended up raising that capital. What ended up happening was those very same hedge funds ended up being sources of supply for us. Rather than being competition, they were who we bought the paper from. When the downturn came, they could not hold onto the capital and they needed to sell the paper when they got withdrawal notice.

Moderator: We have been awash in liquidity since the GFC. You are a lock-up fund, you are private. How do you think about liquidity and how it affects the market place, and inside your individual funds?

Howard: Concern for most people is that liquidity has gotten less largely because banks can’t position for their own accounts. I wrote a memo about liquidity and I said that the best defense against illiquidity is to not need liquidity. And if you have a long-term business model which is based on long-term hold and not trading, then you are fine when liquidity dries up. In fact, when people get desperate for liquidity and they say “I want out at any price”, we can be a supplier of liquidity because we have funds we can call on and that is a great position to be in.  

Rajath: I think the reduction of liquidity is generally a positive for our business. I think that it means there is more fluctuation in market prices as a result of flows in and out of high yield mutual funds or ETF’s and that is helpful to us.

Moderator: You started Oaktree back in 1995, you now have over 900 professionals and manage over $100 billion in assets. Can you talk a little bit about that journey, what sets you and Oaktree apart and where you plan to go from here?

Howard: What sets us apart besides excellent people and high skill level is our philosophy which is highly enunciated and very explicit and uniform across the firm in all the things we do. It stresses risk control, consistency, being active only in less efficient markets, high degree of specialization, non-reliance on macro forecasts, and non-reliance on market timing. I think it’s an effective philosophy and it’s not the only successful one but it’s a good one for us and we stick to it very carefully. We view ourselves as being the low-risk manager in some high-risk asset classes and I think there is a place for that and there are clients who want that. If you are running an investment manage business, be very explicit about what you do and then do it. If you do those 2 things, you avoid 90% of the problems that crop up between investors and their clients. The big problem comes up when somebody says this is what I am going to do and does something else. In my opinion, that guy deserves to get in to trouble. If you are explicit and you are consistent, then you are okay and that is a big part of what we’ve done. Now, if you say why has Oaktree gone from 0 assets in 95 to 100 billion today, I think a big part of the answer is that the things we do come under the heading of alternative investing in the sense that they are not traditional stocks and bonds and that happened to be the right place at the right time. Pension funds and endowments in our country need about 7.5% return nominal and at this point in time, most people have given up on getting that from mainstream stocks and bonds. Everybody needs alternatives so inflows of cash to alternative funds have been very strong. More lately, more people are looking skeptically at hedge funds as the solution so as money flows out of hedge funds, there is $3 trillion that has to go somewhere. The problem for us at the present time frankly is finding investments and is not getting capital. It is very important to be disciplined about that and not take more capital than you have opportunities for. We have a good and effective approach in a very good time.

It is what I would call demographic luck. I didn’t do anything to get into the high yield bond business. My boss at Citibank called me in the summer of 78 and there is somebody named Milken out in California and he deals in something called high yield bonds. Can you figure out what that is? The only thing I did was I was smart enough to say yes. We set up a shop in a certain area and then that turned out to be the area of opportunity. I don’t think we knew in advance that it was going to be.

Moderator: Do you see tailwinds behind the industry whether it’s just assets or how do you maintain returns given the inflow?

Rajath: We are in a low-return world and maintaining historical return is tough. There is no question about it. People will talk about their long-term track records in the alternatives industry. I think a lot of those long-term track records are driven by performance in the early years of their existence. One of the things I try to do when I am looking at track records that is particularly long, I try to decompose how much of that comes from funds that were raised in the 80s and early 90s where it was an easier time to get returns – markets were much less efficient, less competition in some of these areas. Today we live in a low-return world and it is harder to maintain those returns. At Oaktree, what we have been good about doing is scaling up and down – this is a comment generally about Oaktree but particularly applies to distressed funds. When I first started in private equity, I remember there was a transaction that someone had supposedly bid to a 15% rate of return and won and everyone’s jaws were on the table because it was so low. They didn’t actually get the 15% anyway but that’s what they bid it to and that seemed shocking. Today, I think a lot of people would say that’s very typical and that’s where you would bid transactions to. In fact, if you are trying to push the envelope to 20 and 25 all the time, you are probably doing something wrong. You are probably taking too much risk and you are probably pushing the envelope too much. It’s a constant struggle and we try to make sure that when the time is right for our strategies, we have the capital and we try to make sure we stay out of trouble during the other times.

Howard: I would like to add that having the right amount of capital is extremely important. Back in 01 and 02, we had $3.5 billion for distressed and that was a great time because telecom industry melted down. And we had scandal companies like Enron, WorldCom, and Arthur Andersen and people were throwing up their hands and saying they will never trust another CEO or another financial statement. Stuff was literally being given away. We bought bonds in the summer of 02 of great companies that yields between 20 and 70, none of which defaulted. That was our biggest fund to date. Some people would use that track record to go out and raise a fund twice as big. Our approach is that if the stuff we own appreciated 75%, that means the market appreciated greatly and that means the right amount of capital is less not more. So the next fund we raised was $1.2 billion instead of $3.5 billion. Being mature in that sense is what wins you respect and it is a virtuous circle in itself. It starts with the manager resisting the temptation to raise all the money he can.

Moderator: Advice given the careers you have had to somebody just starting out today and/or yourself when you were starting out?

Howard: The great thing about the investment business is that it involves interesting puzzles which are rarely the same twice and a lot of deep thinking. For the most part, you deal with intelligent people on the other side. I think it’s very important for anybody who is starting off in anything to do something that they really like and they are really attracted to and hopefully they are reasonably good at. Over my experience in the investment business and especially in the last 30 years, the investment business became especially remunerative. When I got out of grad school in 69 at the University of Chicago, I applied for 6 jobs in 6 fields and they all paid the same. I happened to take the one in investment management – it was not especially lucrative. And then, something changed in the 80s and it became especially lucrative. That is not a good reason to do it. You should only do it only if you enjoy it and are attracted to it and in that case, you should.

Howard Marks is the Co-Chairman and Co-Founder of Oaktree Capital, a global asset management firm. Rajath Shourie is a Managing Director and Co-Portfolio Manager of Oaktree’s Distressed Debt Group.

Image Source: DealStreetAsia
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