Blue Owl: Structural Risk Hiding Within Revenue Momentum (NYSE:OWL)

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Blue Owl’s (NYSE:OWL) revenue predictability, stemming from a fixed management fee structure, weights against a precarious Business Development Company “BDC” regulatory framework, making it challenging to maintain capital in its investment vehicles, where it derives most of its income. Management’s decision to diversify into real estate and growth-tech, manifested in newly established funds, such as Owl Rock Technology and Oak Street, is a welcomed decision that could enhance its strategic appeal. Still, these funds are nascent, and it remains uncertain whether management will be able to leverage their origination platform, which historically focused on Private Credit, to successfully expand into new verticals.

Short-Term Opportunity

OWL is an asset management firm running several funds, primarily on behalf of yield-hungry retail investors who entrust it with their cash for an opportunity to gain exposure to high-yield investments, namely Private Credit. In return for its services, OWL collects between 1% and 2% fees annually on capital raised from investors, regardless of performance. These earnings represent the majority of the company’s income, offering an attractive, recurring stream of revenue to OWL shareholders but exacerbate structural challenges inherent in the regulatory framework of BDCs, the primary structure of its funds. Before discussing long-term risks, let’s highlight the short-term opportunity of owning OWL.

OWL Business Model

OWL Business Model (Graph created by the author)

Private Credit fundraising was strong in Q2, notwithstanding marginal softness on a YoY basis, with macroeconomic challenges brimming over the capital market partially assuaging a continued search for yield, as rates remain historically low despite monetary tightening. This sentiment was mirrored during Owl Rock’s (ORCC) earnings call yesterday.

The second quarter was our third most active quarter since inception, with over $7 billion in originations across the platform. Craig Packer, CEO, ORCC Q2 Earnings Call

This active market opens an opportunity for OWL to create new funds and attract more capital, expanding Asset Under Management “AUM” and free-related earnings “FRE.” Management is drawing plans to bring two of its funds public through IPOs; Owl Rock Technology and Oak Street public.

U.S. 10 Year Treasury

Yields remain historically low despite recent monetary tightening (CNBC)

Systematic Risks and Long-Term Challenges

OWL structures most of its funds as BDCs, highlighting its commitment to paying a dividend, a value proposition that makes it easier to raise capital. To meet BDC requirements, a fund must distribute at least 90% of taxable income. However, this makes it hard to recover capital when a portfolio company defaults. Nearly 80% of publicly-traded BDCs have lost net asset value “NAV” per share since inception, mirroring systematic challenges within the BDC structure, brimming over OWL in the long run, as the fair value of its BDCs slowly declines, not to mention the reputational damage from an inability to maintain capital, exacerbated by a structural conflict of interest existing between investors and fund managers, whose earnings depend on the fund’s size instead of performance.

BDC NAV per share % change since inception

BDC NAV per share % change since inception (Table created by the author based on data from YCharts and SEC filings )

These systematic challenges, combined with eye-watering fees, underpin a moral dilemma caused by historically low rates, eating away investors’ total returns. Between salaries, business dinners, and corporate jets, these expenses often add up to 50% of interest revenue.

One can’t help but feel cynical looking at financers securitizing management fees into a publicly traded company offering an opportunity to join the winning side, i.e., bankers in the investor/asset manager relationship. Without continuous capital raises, these companies will likely wither away, possibly before investors can recover their capital. Thus, while the economics is sound in the short run, the reputational damage can limit OWL’s ability to grow in the long run.

Summary

OWL derives a significant portion of revenue from the BDC sector, which I believe suffers from systematic shortcomings exacerbated by high management fees, leverage, and excessive risk-taking. Almost 80% of BDCs have lost value since inception regarding NAV per share. This has reputational damage to OWL, as it is unlikely that it will be able to maintain capital in the long run, relying on a continuous cycle of equity and debt funding, making it less likely to gain the ranks of prominent alternative assets managers such as Blackstone (BX). Private Credit companies, namely BDCs, lose hundreds of millions in capital each year, delivering mediocre total returns, eaten away by fund expenses, often adding up to 50% of a fund’s interest revenue.

One can’t help but feel cynical looking at the business model of investment advisors who securitize management fees into new publicly-traded companies, offering an opportunity to switch to the winning side of the manager/investor relationship. As much as I am against management’s high fees from a moral perspective, one can’t ignore the opportunity offered by OWL in the short run. The company is largely immune from the performance of its funds, collecting a fixed fee over fair values, which management determines based on subjective estimates relying on the leadership’s good faith. OWL also profits from rising interest rates, given that most of its funds’ assets are tied to a floating interest rate. The company is also capitalizing on strong demand for high yield, given the historically low-interest rates, allowing it to create new funds and increase AUM.

The only challenge for OWL in the short run is high competition in the Private Credit sector, as an increasing number of asset managers chase a limited number of opportunities, raising prices and pushing valuation higher. These dynamics make it hard to find moderately-priced investments adequately compensating for the risks of investing in the US Middle Market. Our hold rating reflects OWL’s short-term revenue tailwinds, weighted against systematic risks arising from the legal structure of its funds, including distribution requirements and inherent conflict of interest, combined with imprudent investment decisions, including high leverage and management fees and excessive risk-taking.

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