Oaktree’s success, ambition moves firm’s distressed strategy from the shade to the spotlight

This article is provided to FT.com readers by Debtwire—the most informed news service available for financial professionals in fixed income markets across the world. www.debtwire.com

--------------------------------------------------------------------------------

Oaktree Capital Management’s decision to return money to limited partners last February was dubiously hailed as one of the most tangible signs that the market for distressed investing was on life support. But as defaults ticked up in the second half of 2011, it was Oaktree who splayed its branches wide to scoop up credits of all sizes and industries where solvency was at risk.

The move to resume buying as other players held tight gives the firm a pivotal role in shaping the restructuring landscape as it shifts to a new year, Debtwire reports, citing buyside and advisory sources.

During this latest wave of ubiquity – funded mostly from a USD 2.6bn supplementary fund deployed in August – Oaktree hit up not only mainstream distressed credits such as General Maritime and Dynegy, but also swooped into beaten-down capital structures of small-cap issuers, such as trade magazine Hanley Wood and hobby retailer Provo Craft.

Bankruptcy junkies are quick to point out the powerhouse vulture’s return statistics rank near the top of the hedge fund world. Oaktree’s most recent benchmark vehicle, the USD 10.9bn Opportunities Fund VIIb, posted a 16.7% net internal rate of return (IRR) through 3Q11, placing it as a second quartile performer above the 14.4% median for other distressed funds from the 2008 vintage, according to investment research and data provider Preqin. Oak Hill Advisors’ smaller USD 1.125bn Strategic Credit Fund is actually the top performer from the 2008 class, boasting roughly a 27% net IRR through 3Q11, said two industry sources..

But despite Oaktree’s success and the omnipresence that comes with having USD 73bn of total assets under management – 33% of which is allocated to the distressed platform – the asset manager’s profile has largely steered clear of the public lens. That could soon change, however, as the investor last year applied to follow in the IPO footsteps of peers Apollo Management and Blackstone.

Raising the stakes further, the firm is trying to pad its war chest this quarter by raising a new USD 4bn–USD 6bn Opportunities Fund IX that could keep it among the next decade’s dominant sources of alternative capital, said an advisory source, a fund-of-funds executive and a distressed portfolio manager.

For Oaktree, the ability to continually turn corporate pain into large-scale profit hinges on the temperamental art of monetizing current workouts alongside longstanding reorganized equity positions. The fate of Fund IX in particular will be tied to fickle default rate trends and the liability management tactics corporate executives might employ to keep vultures from feasting on the USD 430bn of leveraged debt maturing in 2014 and 2015, the sources noted.

Under the shade

A darling of hedge fund investors for the 23% aggregate gross IRR its 15 distressed funds have produced since 1998, Oaktree benefits from investment vehicle lifecycles that run over 12 years, outstretching the seven- to 10-year standard generally granted to private equity and distressed players, said the financial advisor, the fund-of-funds manager and a lawyer. The longer leeway separates the California-based hedge fund from the pack because their portfolio managers are less sensitive to mark-to-market fluctuations than some smaller shops that fall into the knee-jerk fray when an issuer encounters bumps in the road, the sources said.

A longer horizon has been central to Oaktree’s game theory in a host of recent investments where the money manager staked out secured bank debt positions before trading levels hit bottom. Having more time to run gives the cash-rich fund freedom to focus on aggressively building a position, regardless of whether the short-term trade plays out perfectly, and less on entry point. While the approach may result in an initial trading loss, it’s a small price to pay for a controlling stake at the top of a bankrupt capital structure, the attorney and advisor pointed out.

The firm was a winner in Aleris International’s restructuring, where it built a 15% position in the aluminum roller’s USD 1.3bn term loan. Oaktree bought the debt mostly though secondary purchases in the 70s more than six months before Aleris sought bankruptcy protection in February 2009, said the legal source and a distressed credit analyst. Although the loan traded down to the single digits after the filing, Oaktree stomached the dive and used its first lien status to team with other investors in floating the company a pricey USD 500m Libor+ 1,000bps DIP loan. The DIP was paid out in full at exit 16 months later and pre-petition term loan holders received all of the reorganized equity.

Fast forward to October 2011, Aleris booked a 34% spike in 3Q11 earnings and paid shareholders a USD 3.20 per share dividend. The equity last traded at USD 60 for a USD 1.8bn market capitalization, nearly twice the USD 910m market value implied by the 70s entry point on the old USD 1.3bn term loan, added the analyst.

All that glitters isn’t gold

While betting on the right part of the capital structure is key, Oaktree’s track record is far from perfect. The firm’s strategies work best in credits with real hard assets that are saddled by balance sheets incapable of withstanding industry down-cycles, the advisor and a hedge fund manager said.

The fund bought energy servicer Aquilex’s bank debt in the 80s in 4Q11, betting on a Chapter 11 filing, said a source familiar with the matter. But the bank debt has been earmarked for a par recovery thanks to an out-of-court workout backstopped by a rights offering from junior bondholders who could face bigger losses..

Not all of its forays into the secured debt of distressed, asset-heavy borrowers have produced great victories. For instance, the firm accumulated around 20% of door maker Masonite’s USD 1.4bn term loan in the 70s back in 2008, said the hedge fund manager. The loan then traded into the high 40s during a restructuring process that year, and lenders ended up getting 97% of the equity.

Oaktree has still not broken even on Masonite from a valuation perspective. The company’s current USD 675m market cap, combined with the USD 125m dividend paid in April underwhelms the USD 980m market value implied by the 70s entry point on the old loan, the manager added.

Active stakes in bankrupt newspaper publisher Tribune and bankrupt coated paper producer NewPage are also remarkable outliers to Oaktree’s bread and butter since both insolvencies are more attributable to secular rather than cyclical pressures, noted a second hedge fund manager and a flow desk analyst.

In NewPage, it bought a position in the company’s 11.75% first lien notes in the 90s, but the paper is now trading around 69, said the desk analyst. Meanwhile, Tribune’s USD 5.5bn term loan, of which Oaktree owns more than USD 100m, was last quoted at 58/59, according to Markit.

Planting season

For any buyside shop employing a secured debt strategy, the coming years could be prolific. Just USD 141m of speculative grade bond and loan debt is set to mature between 2012 and2013. However, of the USD 430bn of leveraged debt due in 2014 and 2015, USD 215bn is loans, according to data from JPMorgan and Markit.

Among the biggest players in the at risk post-2013 pool are real estate services provider Realogy, which has USD 920m of bank debt due in 2013 and USD 303m of bonds due in 2014 and 2015; utility company TXU, which is saddled with USD 7.3bn of loan and bond debt maturing in 2014-2015 span; and media giant Clear Channel, which has USD 4.11bn of combined bank and bond debt coming due in 2013 and 2014, followed by another USD 12bn in 2016.

With the bulk of the most daunting corporate debt maturities still more than two years away, the timing of Oaktree’s Fund IX capital raising effort is opportune. Back in 2007, ahead of the Lehman Brothers fallout and subsequent global economic crisis, Oaktree had similar foresight when it raised the USD 10.9bn to back Opportunities Fund VIIb.

In the three months following Lehman’s meltdown, USD 5bn of Fund VIIb’s money was invested in collapsing securities. While the firm was perfectly positioned to capitalize on cheap secondary prices, its AUM was dealt a USD 10.8bn hit since the market had yet to bottom out. But when high yield rebounded in 2009, AUM ballooned by USD 19bn, regulatory filings show.

Officials from Oaktree declined to comment for this story.

--------------------------------------------------------------------------------

For more information or to inquire about a trial please email sales@debtwire.com or call Americas: +1 212-686-5374 Europe: +44 (0)20 7059 6113 Asia-Pacific: +852 2158 9731