Sculptor Capital Management, Inc.
Q3 2014 Earnings Call Transcript

Published: 4 Nov 2014

[Operator:]

Good morning, everyone, and welcome to Och-Ziff Capital Management Group's 2014 Third Quarter Earnings Conference Call. My name is Sonia, and I will be your operator for today. [Operator Instructions] I would now like to turn the call over to Tina Madon, Head of Investor Relations at Och-Ziff. Please proceed.

[Tina Madon:]

Thanks, Sonia. Good morning, everyone. With me are Dan Och, our Chairman and CEO; and Joel Frank, our Chief Financial Officer and Senior Chief Operating Officer. As a reminder, today's call may include forward-looking statements, many of which are inherently uncertain and outside of our control. Och-Ziff's actual results may differ, possibly materially, from those indicated in these forward-looking statements. Please see our 2013 Annual Report for a description of the risk factors that could affect our financial results and our business. The company does not undertake any obligation to update publicly any forward-looking statements. During today's call, we'll be referring to economic income, distributable earnings and other financial measures that are not prepared in accordance with GAAP. Information about and reconciliations of these non-GAAP measures to the most directly comparable GAAP measures are available in our earnings release, which is posted on our website. No statements made during this call should be construed as an offer to purchase shares of the company or an interest in any Och-Ziff fund. Now let me turn the call over to Dan.

[Daniel Saul Och:]

Thanks, Tina. Good morning, everyone, and thank you for joining us. During the third quarter, we made good progress in executing on our strategy to expand and diversify our business. We continue to grow the assets and our dedicated credit, real estate and long/short equity products, which in total, reached $12.6 billion as of September 30, or 27% of our assets under management. This compares with $7.5 billion or 20% just a year ago. We also continue to develop our capabilities as a solutions provider, taking advantage of the deep investment expertise we have in each of our strategies. Our experience has been that institutional investors are increasingly turning to firms, like ours, for this expertise. We believe that we are benefiting from the secular trend of the largest investors increasing their allocations to leading alternative asset managers across multiple asset classes. The integration between our investment teams globally enables us to create additional opportunities, both in terms of potential returns and our ability to offer varying products, which helps our LPs meet specific investment criteria. Our investors have been very receptive to the expansion of the platforms we offer. They remain focused on alternative managers who can consistently deliver strong investment returns with lower risk. We believe we are well positioned to further increase our market share of the growing demand for absolute return strategies to our diversified product offerings and global footprint. Now for a brief recap of our assets under management. As we announced this morning, our assets under management as of November 1, totaled $46 billion, increasing approximately $5.8 billion or 14% from December 31 of last year. The increase was due to approximately $4.8 billion of organic net inflows, which were 83% of the total, and $978 million of performance-related appreciation. Pension funds globally and private banks in the U.S. remained our largest sources of net new capital year-to-date to the end of the third quarter. Together, they represented approximately 50% of our total assets under management as of October 1. We continue to benefit from institutions who invest with us directly. In real estate, we completed the final closing of our third real estate fund in September, bringing total commitments to $1.5 billion. Interest in the Master Fund remained high, with assets under management increasing 7% year-to-date through November 1. The momentum in both are opportunistic, and loan on the credit products is also strong. We closed our 8th CLO in September, and see substantial additional opportunity in this business. Now turning to our investment performance. During the third quarter, market conditions were much more challenging globally. Geopolitical concerns and increased market volatility eroded investor confidence and contributed to rising risk aversion across asset classes. These unsettled conditions persisted in October. With this as the backdrop, we protected investor capital through a consistent approach to investing and managing risk. As always, we actively hedged our exposures and managed our portfolio allocations in a systematic and thoughtful way. We maintain significant flexibility, so that we can always allocate capital to what we believe are the best opportunities to generate risk-adjusted returns as market conditions change. Year-to-date to October 31, the Master Fund had a net return of 2.1% with about half the volatility of the S&P 500. Positive performance in the U.S. credit, the U.S -- and related strategies, partially offset by negative performance in the European and Asian long/short strategies, with the primary drivers of year-to-date net returns. We remain fully invested in the Master Fund during the third quarter, although we adjusted our capital allocations across strategies and geographies as the quarter progressed. We continue to identify what we believe our pockets of opportunity, particularly, in equity special situations and merger arbitrage, as large scale M&A activity remained strong. While spreads in many areas of credit continue to tighten, in some cases exceeding prior highs, we are finding additional opportunities to invest in both corporate and structured credit. With that, let me now turn the call over to Joe, who will take you through our financial results.

[Joel Martin Frank:]

Thanks, Dan. For the 2014 third quarter, we reported GAAP net income of $23 million or $0.13 per basic and $0.09 per diluted Class A share. You can find a full discussion of our GAAP results in our press release, which is posted on our website. Now let me review our economic income results for the quarter beginning with revenues. Management fees were $168 million, up 5% sequentially; and 22% higher than the third quarter of last year as assets under management increased, driven by a combination of strong organic growth and performance-related appreciation. These increases reflect the success we are having in expanding and diversifying our business. Our average management fee was approximately 1.46% reflecting asset growth in our multi-strategy, credit and real estate products. Our average management fee will vary from quarter-to-quarter, based on the mix of products that drive the growth in our assets under management, but our management fees are stable and they're a growing source of revenues. Incentive income was approximately $60 million during the third quarter. About half of this amount relates to the recognition of incentive earned on our first real estate fund. The remainder primarily relates to incentive crystallized and certain longer dated assets. Now for a brief recap of our operating expenses for the quarter. Comp and benefits totaled $42 million. Of this amount, salaries and benefits were $26 million, up 4% sequentially. Bonus expense was approximately $16 million. About half of this amount related to the recognition of the incentive from our first real estate fund, the remainder related to guaranteed bonus expense. Salaries and benefits were 15% of management fees, and we expect this ratio to be 16% to 18% in the fourth quarter. Non-comp expenses totaled $31 million, essentially unchanged sequentially. Non-comp expenses totaled 19% of management fees, and we expect this ratio to remain in the range of 19% to 21% in the fourth quarter. Our effective tax rate for the quarter was 25%. We estimate that this rate will be in the range of 20% to 25% for the full year. As always, this range is subject to variables that won't be finalized until the fourth quarter and, therefore, could change meaningfully. Our distributable earnings were $117 million or $0.23 per adjusted Class A share, and our quarterly dividend is $0.20. In closing, our strategic plan has been driven by providing solutions to our clients. This has had the added benefit of diversifying our asset base by product, duration and source of capital, as well as the benefit of diversifying the timing of crystallization of a portion of our incentive income. To point to just a couple of examples, our standalone credit, real estate and dedicated long/short assets together make up 27% of our total assets under management today, compared with 7% just 3 years ago. And we have nearly $10 billion in dedicated credit assets today, compared with just $1 billion -- under $1 billion 3 years ago. As a result, we've generated very strong growth in our assets under management, while this growth may vary quarter-to-quarter, over the last 5 years, our assets have grown at a compounded rate of 16% and over the last 3 years at a rate of 18%. Our management fees have also grown, significantly, during these time frames. Additionally, while our incentive income may vary year-to-year, the increasing diversity of our business enables us to earn incentive from multiple products across a range of asset classes. This, in turn, should further increase our ability to consistently earn incentive each year. The incentive we earn equals 20% of the profits we generate across virtually all of our products and has not been subject to fee compression, which makes it a valuable revenue stream to our shareholders. In years we've protected capital, but not earned a significant amount of incentive, this outcome is also extremely valuable. This is what our LPs want, low-risk returns compared to the broader markets. This means, protecting capital in a volatile and down markets, and generating strong absolute returns when markets perform. These types of returns leads to strong asset growth, higher management fees and more assets to earn incentive on. Over the last 5 years through October 31, the Master Fund has generated an annualized net return of 7.3% and a sharp ratio of 1.96 delivering significant value to our LPs. The growth in our assets and our management fees, combined with recurring nature of our incentive and a scalable expense base, drive strong earnings expansion over time. Lastly, our dividend policy reflects the benefits of a business that's not capital intensive. Over the last 5 years through September 30, we've paid out approximately 90% of our distributable earnings as dividends, delivering significant value to our shareholders. With that, we'll be happy to take your questions.

[Operator:]

[Operator Instructions] The first question comes from Bill Katz, Citi.

[William R. Katz:]

Dan, maybe first one for you. You mentioned in the books, the press release and your prepared remarks that you're seeing rising demand for your platform. When you look at the flows over the last few months, in particular, things have really slowed down a little bit. So I guess, 2-part question, what's driving that, what gives you the confidence that you could see a pickup of organic growth? And the second part of that question is the Calpers, AUM in or out of their reported numbers at this point in time, they released subject to withdrawal?

[Daniel Saul Och:]

We feel very good about our strategic plan to be a solutions provider to our clients and to develop -- to continue to develop as a multi-product alternative asset manager. Any measure you want to use, 1 year asset growth, 3 year, 5 year, the new products we mentioned $12.6 billion at AUM, up from a very small number 3 to 4 years ago, dialogue we're having with clients. We feel very good about what we've accomplished. We feel extremely good about the future. That comes from both looking at what we have internally that we know we can deliver, as well as what we think clients are looking for. Clause [ph] can be a seasonal episodic. We've had a number of clause [ph] over the years. We've asked about flows and slowdown in flows, but we believe our business is about absolute return. And an absolute return investing is not one month or one quarter that tends to surprise an upside, but we found over 20 years. If you do it properly, there is compounding and growth. And as you grow, people see more and more value. We think that's what we have in terms of our strategic plan. And we're going to continue to execute.

[Joel Martin Frank:]

In terms of Calpers, we don't disclose specific asset growth. But I'll also add to Dan's point, and even looking at year-to-date. Year-to-date, our net flows -- through September 30 of $5.4 billion, compared to about $2 billion in 2013. Again, they can be episodic, they can change, but that's significant organic growth regardless of how you look at our year-over-year.

[William R. Katz:]

And just one other question from me, and, I mean, I'll get into queue. Just from a big picture perspective, just given where the stock is trading, any thoughts of potentially shifting your payout structure to lower the payout to give you a little more capital flexibility to repurchase some shares. What are your thoughts when you think about that dynamic?

[Daniel Saul Och:]

Look, we think about the best use of the dividend flow and, of course, that's part of the discussion. We haven't concluded any of that. In fact, using some of the cash flow to invest in products and do other things is another part of what we discuss. So we're constantly thinking about it. We haven't concluded anything specific, but it is a part of our discussion.

[Operator:]

The next question comes from Daniel Fannon, Jefferies.

[Gerald E. O'Hara:]

It's actually Gerald O'Hara sitting in this morning. Just -- could we get a quick update on where we stand in terms of the longer-dated assets. Potentially, maybe even a little about demand, but also just kind of the absolute number as it currently stands at the end of the quarter?

[Daniel Saul Och:]

Yes, so 32% of the AUM is in our longer-dated assets, which includes our 3-year tranche real estate and some of our credit assets.

[Gerald E. O'Hara:]

Okay, great. And also, is there any update you might be able to provide just around the retail offering, whether it be just -- thinking about it, infrastructure or anything that you might be able to add color-wise?

[Joel Martin Frank:]

Look, there are lot of product that we think about doing. And of course, retail is one of them. Whether that's a 40 Act fund, whether that's a BDC, whatever it's going to be, we're constantly discussing that and thinking about what's the best for our business, what's the best way for us to access that market. I mean, obviously, you know the private bank platform, which is a big part of our assets, is something that we've accessed, and we've accessed fairly well. It's about 70% of our AUM. So I think that's one venue that we've been through, but of course, we're always considering the other venues as well.

[Gerald E. O'Hara:]

Great. And one last question quickly, while I have it. The incentive income generation from the first real estate fund, is that also something that's going to be just a function of when realizations occur? Or is that something that is, actually, a little bit more, I guess seasonal in nature, something we might be able to kind of model in going forward -- not model in, but is it something that the third quarter will see maybe, potentially increased activity? Or is it spread throughout the area episodically as you might say?

[Joel Martin Frank:]

It's spread throughout year, but certainly, related to realization. But also, there are other aspects. It's a private equity structure. So you have to get that callbacks and other stuff before we actually take it in to cash flow. Remember, we are dealing with cash flow. So when we actually collect it, we'll take it in. And there are some bonuses tied to that. So I don't expect -- I'll try to give a guidance, when I know this is going to happen. I don't expect it to be material through the end of this year and through next year but that could change. And if that does change, I'll obviously give you guidance as best I can.

[Operator:]

The next question comes from Robert Lee, KBW.

[Robert Lee:]

I was just curious, I mean you guys had a lot of success with CLOs in the last couple of years, clearly. I mean, what are your thoughts on the shifting CLO rules around risk retention, because traditionally, you haven't retained a lot of capital and perspectively at some point in the future, you may need to retain some capital to issue CLOs. So just your thoughts on how you think that impacts your business going forward.

[Daniel Saul Och:]

Well, first of all, obviously, we've been aware. This is something that risk retention has been around in Europe at those European CLOs. And obviously, we know it's coming here. So we know a part of our business to plan for that. There are many ways that we could fund this, whether it's out of cash flow if we think that's the right thing to do, or other ways of funding, is that we've been planning and thinking about, again, using the balance sheet to invest in products is one way of doing it. And depending on where that source of cash comes from, we'll figure it out. But there are many, many ways of doing it. We're well aware. But we also think, obviously, some of the bigger providers like us, the people who are investing in this, you have to have the wherewith along the capital to do it. So we think that that's an important part of the CLO business, and continuing the CLO business is having those resources to do it.

[Robert Lee:]

Okay. And maybe, a question a little of a modeling fourth quarter question. If we think ahead and given where performance is year-to-date on a gross -- excuse me, on a net basis. What's the right way to be thinking of the potential incentive compensation? Is 2011 a good template in the sense of when there was a year where the performance fee generation was less than in other years. Is that a reasonable template to look at for how we maybe want to think about compensation expense in Q4? Obviously, we don't know what November and December will bring. But is that a reasonable template, is there kind of a percentage of total revenue that we should be thinking of as a reasonable range to try to think about compensation expense?

[Daniel Saul Och:]

Sure, I think. Look, I think if you look over the last 2 years, the bonus percentage of total revenue is something to look at. Certainly, 2011 is the year that you could focus on. But I would look over the last several years as a proxy for what you should do and as a percent of total revenues.

[Robert Lee:]

Okay, great. And one last question. I know part of the incentive fees this quarter were related to realizations in the real estate fund. In terms of there isn't a lot of visibility into it, is there any way of giving us a guide in terms of real estate and other products that may have -- that have a generic performance fees on realization, kind of how -- what kind of the embedded games maybe on those kind of in aggregate? Obviously, we don't know the timing, but are we thinking that there's $2 billion of kind of investment gains to be harvested over however many coming years? I mean any color on that I think would be helpful for us.

[Daniel Saul Och:]

Right. Look, I think we tried to give as much guidance as we can, when and if we know these things are going to be realized and taken into income. Right now, I don't expect anything significant but, of course, to the extent I can going forward, I will certainly give you guidance.

[Operator:]

The next question comes from Ken Worthington, JP Morgan.

[Kenneth B. Worthington:]

This is Amanda Yel [ph] for Ken. Can you talk about the returns in the non Master Funds? How were the returns in credit and real estate this year? What percentage of your AUM in products that are below their high water marks, and therefore wouldn't be eligible for performance fees, if the year were to end today?

[Daniel Saul Och:]

Well, the performance -- we don't disclose performance in those trends, but I'll tell you the performance has been very good. Obviously, the credit funds have been performing very well. It's one of our bigger performance for the year along with -- followed by long/short equity. In terms of assets in our longer-term funds, I think you get a sense longer-term assets of 30% -- 32% of AUM are credit assets, are close to $10 billion. So I think you get a sense of what we're going to do, $1.5 billion in the real estate funds to give you a sense of size. And although, we don't have any numbers, performance has been very good. And we'll give you whatever we can going forward, that's one thing that we have been thinking about and discussing in terms of disclosure of some of the longer-dated assets and some of the other asset classes.

[Operator:]

The next question comes from Mark Irizarry, Goldman Sachs.

[Marc S. Irizarry:]

Dan, can you just give us some perspective, long/short equity special, I guess is 63% of Master Fund. You think about the opportunities going forward and just that being 2/3 -- almost 2/3 in that strategy. Now, how do you sort of expect the opportunities over time to shift in terms of your investment strategy. And I guess, related to that, the longer you stay in, let's say, long/short, does that sort of affect the way maybe investors view the opportunity in terms of allocating towards Och-Ziff, there maybe some perspective on how maybe LPs will react to being more heavily long/short?

[Daniel Saul Och:]

The venture in long/short is one of the areas that we've been very focused on for the past 12 months or so. Primary focus is in the U.S., where we see a very strong diversified event cycle and reasonable clarity in terms of economic conditions and outcomes. We've also got a very opportunistic focus in Asia, where there are some things going on in Japan and China, in particular, that we're very focused on and feel that we have a very strong handle on. So it's very important to note, you saw the numbers for October. Our ability to manage risk and our ability to stay hedged, we think is something that has differentiated us and we think is something that we continue to do, and that's important. And clients are very focused on not just upside return, but they're focused on downside control. And we think this is another episode that demonstrated what we do. Our clients are very comfortable with our allocation. They understand why we have allocations. They understand the opportunities that we see. They know that we focus not just on the upside opportunity, but on downside risk and liquidity. The ability to change our minds and move or something, makes sense. So they know we are and they understand our model and what we focus on.

[Marc S. Irizarry:]

Okay. And then, just in terms of the regulatory landscape, given maybe LCR or a different liquidity roles that are out there. Is that affecting, you think the forward opportunity in some -- maybe some of the odd businesses or other areas of historically where you've been active?

[Daniel Saul Och:]

Well, we do think that over the past several years, a number of the regularly changes and reductions in balance sheets, reduction by banks and investment banks in terms of some of the businesses that are involved in, have created some opportunities. Some of them we pursued opportunistically, such as a market event. And some of them we've pursued as real strategic business opportunities, such as some of the things we've done in the credit area. And so we think -- I don't know if they, specifically you mentioned is going to be relevant, but we absolutely have been clear for several years that the changing nature and behavior in banks and investment banks creates opportunities for our firms and our LPs. And we intend to continue to pursue them.

[Marc S. Irizarry:]

Okay. And then, can you remind us, again, redemption notices for year end. Any -- I guess how much of your AUM is sort of on a -- we get sort of an annual redemption notice, and when they'll sort of -- would those come in?

[Daniel Saul Och:]

We generally don't disclose that. Again, most of the capital is subject to 45 day notice. We have some shorter notice period still. And we'll give you a better sense once we know.

[Operator:]

The next question comes from Bulent Ozcan, Royal Bank of Canada.

[Bulent S. Ozcan:]

I had a question regarding the investor base. So if I look at it as of 3Q '14, about 32% of your investments are based in North America. Now, if you go back to 2019 that used to be about 57%. And my question is, are we going to see an increase in, basically, other regions outside of the U.S. in terms of this ratio, such as in Asia and Europe? And if so, what's -- what are you undertaking to basically broaden your footprint outside of the U.S. or North America?

[Daniel Saul Och:]

Well, we don't focus on the ratio. Our goal is to excel in all 3 regions, as well as any other part of the world where we're going to focus. And sometimes there are opportunities to expand the investor base, and sometimes there aren't. I think, Europe is a pretty good example. Europe went through a period where for reasons endemic to Europe, it was difficult to raise assets, but we maintained our focus. We are more positive about perspective inflows from Europe than we have been in the past several years. We think there are some new things that we can do in Asia. So our goal is to expand those regions, but we don't think of it as a ratio. If we expand both those regions and do as well as we can do, we're also going to want to try and expand North America, as much as is appropriate, and the ratio will be what the ratio is.

[Bulent S. Ozcan:]

Okay. And in terms of the discussions that you're having, I mean, there is a lot of news on the pension funds, basically, trying to reduce the exposure to hedge funds on the other hand. It's like there are also severance funds who are actually getting more involved in that space, who want to increase the exposure. Could you give us some perspective on the discussions that you're having with these severance funds? And if we should expect some flows from severance funds, basically, making up some of the outsource that might happen by pension funds reducing the exposure to hedge funds?

[Daniel Saul Och:]

We don't know what activity will be going forward in any of the different classes, pension funds, private banks, endowments, other sources. Our goal is just to remain, and maintain our premier position where we have that position, and expand in terms of new products and new relationships. And we think you're seeing it. I know we've gone through these numbers before, but we think that they're very important. 27% of our AUM, now from products that essentially didn't exist several years ago. Approximately $14 billion as Joel said, in long-dated assets, something that we as a firm did not have several years ago. We think that shows several things. It shows that clients are committing capital to offset the ways that they didn't do previously. It shows that clients are big believers on Och-Ziff on a long-term basis, because you don't commit long-term capital from that -- you don't think it's getting better over time. It increases the stability of the firm. It increases our attractiveness to employees, and our ability to generate investment returns. And as you've seen, it increases the diversification and stability of the firm, and sometimes that manifests itself in terms of long-term capital and sometimes it manifests itself in terms of an incentive allocation occurring during a quarter other than the fourth quarter, growing in diverse management fees. So we think those virtuous circles are in place. And since they start with investment excellence and providing value to the LP, we think those virtuous circles will remain in place.

[Operator:]

The next question comes from Bill Katz, Citi.

[William R. Katz:]

Just a follow-up on new growth opportunities. As you look out to 2015 and beyond, certainly appreciate the migration of the franchise. What specifically might you be targeting in terms of opportunity? And maybe the question really is neither you scaled some of your long-term AUM, are you at a point now where you could start to step function that AUM in terms of being mandates, because a lot of your peers are chunking in some very big mandates, so I'm curious, if you now sort of hit that level of infrastructure.

[Daniel Saul Och:]

Well, in terms of new products, we don't have anything specific to comment on now. We really mean what we say about solutions providers. So it's driven by -- our discussions with clients tend to be where do we see investment opportunity, either now or going forward, where we have capabilities, and how does that fit what they're looking to do. I think clients have shown that they're willing to make commitments. We have some very large commitments, some very long-term commitments. I hope going forward, Bill, to answer your question. I hope that, that may continue to make those types of commitments to us. But I do think we have what needs to be in place. I would understand why -- as I commented to the last question, I think you've seen that over the past 4 years. Clients don't commit $14 billion in long-term assets to a firm that they don't believe has the infrastructure, investment capability, stability and growth going forward.

[Operator:]

That concludes the question-and-answer session today. I will now turn the call over to Ms. Madon.

[Tina Madon:]

Thanks, Sonia. Thank you, everyone, for joining us today and for your interest in Och-Ziff. If you have any questions, please don't hesitate to contact me at [phone]. Media inquiries should be directed to Jonathan Gasthalter at [phone].

[Operator:]

Thank you for dialing in today. This concludes the presentation. You may now disconnect. Good day.