It was a December to remember. There was head-spinning volatility in equity markets around the world, a fourth rate hike by the Federal Reserve, a partial US government shutdown and escalating tariff fights between China and the US. In other words, enough bad news to provoke forecasts of a global economic slowdown in 2019.

For a distressed credit specialist like Los Angeles-based Oaktree Capital Management, a market plunge should mean imminent investment opportunities–and the firm thought there would be. Indeed, during an earnings conference call in early February, co-chairman Howard Marks reportedly acknowledged he was “starting to salivate” back in December. But the market rebounded in no time and there was no major pick-up in distress deals.

For firms like Oaktree, such a false dawn and return to markets “bobbing along the top” of their cycles–as delegates at PERE’s Asia Summit heard last month–could feasibly be frustrating. Running multiple pools of capital with timers attached in such an environment makes life for the $120 billion-asset manager more challenging as it tries to meet its return targets. Oaktree’s distressed debt strategy recorded a composite gross return of 10 percent last year, down from 18 percent in 2017. Meanwhile, composite gross returns for the real estate opportunities strategy was 15 percent versus 13 percent a year earlier.

Nevertheless, Marks said the firm still put $4 billion to work out of all its closed-end funds across strategies in the fourth quarter last year, despite the “seemingly crumbling” environment.

But he also acknowledged how the weakening of deal structures, including the disappearance of loan covenants, could delay the timing of defaults. “The stage has been set through what we call around here ‘the unwise extension of credit’ and, in particular, the heavy reliance on adjusted EBITDA” for elevated opportunities, Marks said. “But we need an igniter and that will probably require a recession because, especially given the absence of covenants, you’re unlikely to get much of a pick-up in defaults and thus opportunities for us until you get a recession.

In this light, John Brady, Oaktree’s real estate head, who participated in the four-day Hong Kong conference, is thinking sanguinely about the firm’s real estate investment strategy. “You can worry a lot about a potential recession. It looks like trade tensions are going to resolve, but corporate assets are under more downward pressure in terms of leverage levels, so I think a demand shock could impact real estate,” he tells PERE. “But, if you think about capital flows, and the fact that real estate around the world is not over-levered, except in China and Japan to an extent, private real estate is not likely to trade down–if owners are not forced to deal with debt problems.”

“Real estate investing is still attractive because of the attractiveness of debt that is available. It is not a question of if that changes, it is a question of when and where everybody will stand when that changes”

Fundamentals are strong

In fact, Brady says December was not as bad for the real estate sector as it was for other assets.

“We have seen selected markets have strong performance through the fourth quarter and the first quarter [this year] because fundamentals are strong. And, in domestic [US] terms, the distressed cycle hasn’t really started. So, as we look at the micro-cycles and the opportunity set, we have generally avoided those areas where we’re likely to see distress. The only palpable distress in the world today on the debt side is China NPLs.”

PERE spoke with Brady as it was announced a 62 percent stake in his firm was being acquired by Brookfield Asset Management in a deal that sees the Toronto-based real assets giant pay approximately $4.7 billion. Brookfield’s majority ownership of Oaktree’s business, once completed, will create an asset management behemoth with assets under management of $475 billion. It gives Brookfield, predominantly a real estate, infrastructure and private equity business, an immediate and sizable foothold in an area it lacked: credit. As of December 31, almost half of the $120 billion of Oaktree’s assets was invested in credit sectors; the bulk of it in distressed debt, followed by high-yield bonds, senior loans and alternative credit, among other investments.

Brookfield’s real estate business, at $188 billion in assets under management, dwarfs the $9.5 billion of assets on Oaktree’s books. But Oaktree’s real estate strategy is expected to complement Brookfield’s and, as such, is expected to continue to operate under its own steam.

“To use a boxing analogy, we are both champions. But Oaktree fights in the ‘middleweight’ category while Brookfield is in the ‘heavyweight’ category,” remarks Brady. “As such, we believe we will invest successfully and can thrive independently of each other.

Oaktree appreciates the long runway to operate independently and entrepreneurially with the support of a powerful strategic partner. That said, Brookfield is buying into the perspectives and convictions of Oaktree senior management. Brady has plenty of both. From 1,000 feet, he is optimistic about how the asset class still is being viewed as a safe harbor to place capital in the current environment. He agrees there were concerns going into December about the upward pressure on interest rates, but those have been largely eased after the fast recovery. He also agrees there is a vast amount of available liquidity in the market for both equity and credit strategies, though the nature of the capital has changed.

“Wall Street is not as formidable as it used to be,” he remarks. “The number of regular-way lenders globally–particularly on the bank side–has shrunk dramatically due to regulatory pressures. At the same time, there has been this democratization of unregulated debt fund capital and the number of debt funds has grown dramatically.”

The proliferation of the latter kind is reflected in PERE’s data for closed-end private real estate debt funds: as of January 1, 2019, there were an estimated 141 funds in the market seeking to raise $48 billion in capital. At the PERE Asia Summit, delegates heard how most of the debt products in the US have largely concentrated in the higher risk spectrum; opportunistic debt strategies targeting 10-15 percent returns and value-add with a 5-10 percent range.

In Brady’s view, most of the debt funds are small in terms of size. “A lot of the highly focused and specialized debt funds that are smaller and more niche will face more challenges, because in a fast-moving world you have to be able to navigate to where the best risk-adjusted returns are globally, and it’s very hard for small funds to operate in that environment,” he says. However, Brady believes the vast quantities of credit available for real estate continue to give the sector momentum. “Real estate investing is still attractive because of the attractiveness of debt that is available. It is not a question of if that changes, it is a question of when–and where everybody will stand when that changes. That is the kind of distress you worry about. You don’t see it on the horizon, but it is coming at some point.”

The problem of plenty could be Oaktree’s too. In its earnings call for the quarter ending December 31, Oaktree reported $19 billion in dry powder across all strategies. The specific amount of uninvested capital for real estate was not disclosed. But the firm only closed its latest real estate debt fund at nearly $2.1 billion last September, at nearly twice the size of its predecessor, the $1.1 billion Oaktree Real Estate Debt Fund. The firm is also planning to launch its eighth opportunistic equity fund this year, chief executive Jay Wintrob added during the call. The previous fund, Real Estate Opportunity Fund VII, attracted $2.92 billion in 2016, with commitments from the Teacher Retirement System of Texas, Houston Police Officers’ Pension System, and City of Fresno Retirement System, among others. According to a quarterly performance review published by US pension plan Contra Costa County Employees’ Retirement Association, which had a$65 million commitment, the fund was generating a net IRR of 39.7 percent as of December 31, 2018–well ahead of typical opportunity real estate fund expectations.

When asked how Oaktree is thinking about deploying its uninvested capital at this point in the cycle, Brady talks about the need for discipline. “We have no goals in terms of the amount of capital we stockpile. It’s really about positioning to take advantage of opportunities as they present themselves,” he says. “The great thing about the investing environment today is there is really no such thing as a monolithic single cycle where the whole market is high, low or somewhere in-between. The fact is there are many micro-cycles at work at all times.”

“The [distress] opportunity is going to be dependent on when the banks say, ‘Okay, we can’t just keep refinancing,’ and it’s really hard to predict that”

An LP-friendly concept

This philosophy is somewhat reflected in how Oaktree is handling its latest funds. For instance, the firm has been delaying the onset of their investment periods–when fees on committed capital start being collected. One example is Oaktree Opportunistic Fund Xb, a closed-end opportunistic distressed debt fund invested across different asset types, including real estate, with $8.8 billion in total committed capital. The fund is a parallel vehicle to its $3.6 billion Opportunistic Fund X, the two vehicles part of Oaktree’s so-called A-B fund structure, which allows flexibility to have enough committed capital at hand in case the market for distress picks up pace and the opportunity set increases. Fund Xb was understood to be 19 percent invested at the time of the earnings call but, as Dan Levin, chief financial officer for Oaktree stated, the firm had not yet turned on the official investment period for this fund.

PERE understands the firm has also delayed starting the investment periods for certain of its real estate-specific funds, without mentioning which. Brady says: “It is an LP-friendly concept that suggests we don’t want you to pay us a lot of fees until we’re ramped to a point where there is meaningful critical mass and momentum–and, in that vein, justifying our revenue streams. In the long-term, LP-friendly or LP-first approaches to investing capital is a long-term value creator, versus a short-term grab for revenue.”

To get deals done, the firm is believed to have started using subscription-line financing for some of its real estate funds. “We have always been very profit-driven within our real estate franchise. As of December 2018, we have never had an equity fund perform lower than a 1.5x net multiple. And our average has been a 1.7x net,” Brady says. Explaining the use of subscription-lines, he adds: “Real estate is less focused on IRR. But there has been a movement to, I’ll say, play IRR games. And subscription lines allow you to do that. We have, in certain respects, submitted to the desire of many of our LPs to focus on IRR–as well as profitability–even though subscription lines are slightly dilutive, given the structure of interest rates. So, we do now use subscription lines like we haven’t before.”

In terms of where Oaktree outlays are happening, it is betting on high-growth areas where technology is driving job creation. In the US, this means Atlanta, Charlotte, North Carolina, Texas, Phoenix, Denver and others. New York, on the other hand, is a mixed story; while certain parts of Manhattan, such as Chelsea south and downtown, are benefiting from tech-fuelled job growth, others are struggling.

“Midtown office is over-supplied relative to the lack of growth we are seeing in financial services. Luxury for-sale condominiums in New York are stalled; the buyers aren’t there. There is a lot of vacancy in retail; prices have to go down,” says Brady. “ Almost every category of real estate is under a lot of negative pressure. Without too much leverage in the system, those owners are going to try to wait through that cycle.”

Sector-wise, the firm has consciously avoided retail, just as other managers have, given the disruptions impacting the sector. In the US, for instance, retail transaction volumes dropped 49.7 percent on a quarter-on-quarter basis to $14.8 billion in the fourth quarter of 2018, according to data from property services firm Cushman & Wakefield.

“Generally speaking, retail is a sector where you need tenant power and unless you have a dominant position vis-à-vis tenant relationships, it is very difficult,” Brady says. “Shopping malls are increasingly about entertainment. Therefore, to attract tenants to the lifestyle center, you need restaurants and new concepts. Restaurants are risky, they often fail and they require massive amounts of TI[tenant improvements]. So, the retail experience is challenging to deliver and very risky.”

Conversely, Oaktree has diversified across other strategies in recent years, partly as a defensive play and partly to expand its sources of capital. For instance, in February, the firm partnered with New York-based investment firms Silverpeak and Legacy to acquire a portfolio of data centers in Cleveland and Cincinnati. This investment was made via Oaktree’s opportunistic strategy. Then, last February, Oaktree launched a $2 billion non-traded REIT called Oaktree Real Estate Income Trust to raise retail capital for investing in income-producing assets and real estate-related debt investments, joining firms like Blackstone, Starwood and Nuveen Real Estate, which have launched similar products.

Waiting for distress

For a firm with $22.26 billion in distressed debt assets as of December 31, 2018–the largest cohort among the credit investments in its portfolio–recognizing market downturns is a key element of Oaktree’s investment strategy.

“The [distress] opportunity is going to be dependent on when the banks say, ‘Okay, we can’t just keep refinancing,’ and it’s really hard to predict that,” Brady says. “Right now, there’s a lot of liquidity in the debt markets for real estate globally, outside of China. As of now, [distress] has not been the focus of liquidity providers on the debt side.”

Indeed, the only palpable distress Oaktree can see on the debt side is in the non-performing loans sector in China. The crackdown on China’s shadow banking sector, together with a slowing economy and the US trade war repercussions, has led to sizable growth in the number of NPLs coming to the market. A report published by PwC in November estimated a 25 percent growth in the quantum of distressed assets in China from December 2016 to June 2018. As of June, nearly $282 billion of NPLs were reported by banks on their balance sheets, and an additional $493 billion comprised of ‘special mention’ loans, referring to loans outside the NPL category showing signs of distress. PwC also estimated around $620 billion of NPLs sitting with China’s asset management companies. The report expects NPL portfolio investment opportunities to continue being available to foreign investors for at least the next two to three years. According to a Bloomberg report in September, Oaktree acquired 115 non-performing loans from China Huarong Asset Management for 2.4 billion yuan ($360 million; €320 million). “We are on the front-end of the cycle in terms of the opportunity set in China,” Brady says. “On a go-forward basis, China is likely to be the most important market in APAC for us.”

Since its founding in 1995, Oaktree has grown into a powerhouse investor with an enviable roster of credit strategies thanks to making convicted plays like this. That is why Brookfield is buying in, as much was admitted by the firm’s chief executive Bruce Flatt in an interview with Forbes last month: “Both of us have great businesses, and we could have carried on doing what we are doing,” he said. “We could have built a credit business on our own. But it would have taken 15 years to build what Oaktree has.”