OWL - Blue Owl Capital: Why Every Investor Needs To Check It Out

Summary

• Blue Owl Capital Inc.'s business model is thoroughly designed and arguably the best in the alt management industry.
• Blue Owl's valuations are modest and its management expects about ~30% annual return over the next 3 years.
• Despite its high promise, investors may want to moderate allocations to Blue Owl Capital Inc. vs. other alt managers on a risk-adjusted basis.

My readers kept asking me to write about Blue Owl Capital Inc. (OWL), and I understand why. The topic is rich and promising. In certain ways, Owl's business model touches upon the very basics of the investment process. Welcome to the charms and risks of Blue Owl!

A primer on alt asset managers

What follows is an ultra-condensed manual on the alt management industry. If you know the industry - skip the section. If something below is not self-evident for you, please read "How Brookfield and Peers Make Money..." . Industry understanding is a must for figuring out Owl.

• Alternative ("Alt") assets are everything other than public-trading stocks, bonds, and cash instruments. The most popular alternative asset is private equity followed by real estate, private credit, natural resources, infrastructure, renewables, and some others. Since alt assets do not trade publicly, they are illiquid and may take years to sell.
• Alt managers source funds mostly from institutional clients with long investment horizons such as pension plans, college endowments, sovereign funds, and so on. Clients' contributions are organized in so-called private funds that differ by vintage and strategy. Alt managers handle simultaneously tens of private funds with a typical lifetime of 7-10 years during which clients' monies remain locked. When a fund winds up, clients receive back their contributions with profits. Since alt managers have to consolidate private funds in their statements, their GAAP reports are difficult to understand.
• Recently, alt managers have started attracting funds from high-net-worth and mass-affluent individuals as well (the so-called retail or wealth channel). These funds are aggregated into public or private investment vehicles. Despite certain hiccups, it is considered a promising channel for growth.
• Some funds and/or investment vehicles for institutional and/or retail clients are permanent in the sense that contractually nothing limits their lifetime and/or requires their wind-up.
• Some alt managers invest their own significant funds along with clients to achieve alignment of interests and are called asset-heavy. Others try to invest as little as legally possible and are called asset-light.
• The biggest alt managers include 6 companies (that I call the "Big Six") but 7 stocks: Blackstone ( BX ), Brookfield Corporation ( BN ), Brookfield Asset Management ( BAM ), Apollo ( APO ), KKR ( KKR ), Carlyle ( CG ), Ares ( ARES ). Each of the Big Six has its unique strategy and several of them have beaten the market over the long term. All of them are more volatile than the market and currently several of them are trading at a high dividend yield.
• Alt managers charge clients fees. For asset-light managers, these fees dwarf all other sources of revenue. Asset-heavy managers can count on returns on their capital as well, but fees are still the most reliable and valuable part of their business. Fee-related earnings ((FRE)) is the most important line item of an alt manager's income.
• The clients agree to pay fees since normally (but not always) the returns they receive AFTER FEES are higher than they can achieve otherwise. An alt manager's performance track record is a valuable intangible asset that is highly cherished.
• Fees can be divided into management fees charged as a percentage of clients' funds (similar to mutual funds but higher) and performance fees. Smaller advice and transaction fees charged on a per-event basis are usually grouped with management fees. Management fees are stable and predictable as they are being charged quarterly while a private fund exists. Some performance fees are assessed periodically as well but can be zero if investment targets are not reached. The best-known performance fee is the so-called carried interest ("carry") that represents a slice of investment gain/income received by an alt manager only when a fund is wound up provided its investment performance is above a certain hurdle rate.
• Since fees are dependent on assets under management ("AUM"), AUM is the single most important metric for all asset managers. When we talk about industry growth, we mean growth in AUM. The total of alt AUM today is estimated at $13T with 40% of them in private equity. The Big Six forecast growth in AUM at ~16-20% over the next five years or so.

Owl's business model

Doug Ostrover, Owl's CEO, must be the main architect of the business model that I would describe as an alt manager's dream. This model was thoroughly designed and built from scratch to avoid legacy issues. Here are its main features:

1. The model is FRE-centric. Fee revenues consist almost exclusively of management fees that are particularly valuable due to their stability and predictability. Owl does not have any private equity business and does not depend on fickle carry.
2. Even though Owl is much smaller than the biggest companies in the industry, its FRE margins of 60%+ are second to none.
3. Close to 100% of the capital Owl manages is permanent. The capital under management today is never supposed to leave the system and each round of fundraising keeps adding to AUM without any fund outflows.
4. Owl has three carefully selected business lines that I will describe later. It is a leader in two of them and a significant player in the third.
5. Owl is asset-light which means that it does not face direct risks to its capital.
6. From the very beginning about 7 years ago, Owl pursued business from both institutional and retail channels and treat both channels the same. In the retail channel, it is second to only Blackstone.

All items above are highly desirable for an alt manager but none is close to Owl in terms of model perfection (albeit other alt managers have different attractions).

Business lines

Owl operates identically in its three business lines - it raises permanent funds from institutional and retail channels without adding its own capital, invests these funds plus leverage, and charges fees on AUM. The way Owl invests the funds varies between business lines.

Direct Lending is the biggest line (~50% of AUM). Doug Ostrover started it about 7 years ago from scratch. He noticed it was more profitable and safer to lend big rather than small. There are quite a few private lenders ready to lend $10-50M. But the competition is less brutal for loans of $500M and higher. At the same time, bigger loans are required by bigger companies that are more likely to survive and pay off a loan. Somehow he managed to raise $5B for his first fund and that was the beginning of what would eventually become Blue Owl.

Owl primarily provides senior secured loans with floating rates of about 10-15%. One may wonder who needs these loans since banks' rates or bond rates are much lower. The answer helps to understand how Owl operates.

Most borrowers are private equity companies aka sponsors. Per Blackstone, there are about 10,000 companies in alt management worldwide and most of them are sponsors. Owl tracks about 700 of the bigger ones in the U.S. and has lent to 500 of them.

For sponsors, Owl offers several advantages. First, banks originate only about 20% of U.S. debt and cannot satisfy all applicants, especially those of lower quality. Secondly, Owl and other private creditors may be more flexible in structuring a loan. Third, Owl responds quickly and with certainty. Fourth, sponsors may be reluctant to issue bonds to avoid public reporting. Fifth, sponsors may anticipate some future misfortunes. Under this scenario, it is easier to negotiate with one reasonable lender vs multiple syndicated lenders or public bondholders.

Demand for direct lending is high and the business is quickly growing. Almost all major alt managers are involved in direct lending and Owl is an important but not the biggest actor. So far, Owl has avoided trouble in Direct Lending by carefully selecting credits and terms.

Owl's second business line is called GP Capital Solutions (~36% of AUM). It consists of buying minority equity stakes in other private equity companies. Since these companies are general partners ("GP") in their private funds, it explains the name. Blue Owl was formed by merging Mr. Ostrover's lender with Dyal, the company that was providing GP capital solutions.

Owl is #1 in this business - it controls 60% of the market and has only two big competitors - Blackstone and Goldman Sachs.

Why do sponsors sell minority stakes? Private equity operations involving leveraged buyouts are quite risky. Ideally, a sponsor would like to execute buyouts using solely other people's money - both equity and debt. However, investors in sponsors' private funds require alignment of interest, i.e., they want sponsors to have skin in the game and put their capital at risk as well. Often, this capital is not in place and Owl can help for a price. Namely, Owl buys minority stakes at a big discount to public valuations. When it happens, investors in Owl's funds (they are still called Dyal funds) receive fees and carry collected by investees.

Real Estate is the smallest line (~14% of AUM). This business was acquired when Owl was already public. It consists of buying triple-net lease rental properties in the U.S. and Canada. A triple net lease means that all rental expenses (RE taxes, maintenance and repairs, and insurance) are borne by the renter. The owner does not have anything to worry about as long as the renter is creditworthy, the property is essential for the renter's operations, the rent accelerator is in place to protect against inflation, and the term is long enough. This is precisely how Owl operates. So far, not a single monthly payment has been missed even during Covid. It might be Owl's best business line and I wish it were bigger.

About 86% of Owl's business (almost all of Direct Lending and all of GP Capital Solutions) is dependent on private equity. That's why investors in Owl are making a bet on private equity as an industry in addition to betting on a specific alt manager.

Growth and permanent capital

Strong growth and modest valuations are the main arguments for buying Owl. We will focus on growth first and deal with valuations later. Please note, that Owl's financial history is very short (it went public in May 2021 through the business combination with a special purpose acquisition company) and it limits the validity of any financial analysis.

FGAUM (fee-generating AUM) have grown ~38% over the three last quarters which is particularly impressive as funds are permanent. Every dollar coming up under the management of Owl is supposed to stay there.

Some people understand the word "permanent" literally which is a mistake: permanent DOES NOT mean eternal. Let me explain it using a simple example.

The word "permanent capital" is almost synonymous with Berkshire Hathaway ( BRK.A , BRK.B ). In 2016, BRK acquired Precision Castparts (PCC) for a whopping $38B plus the assumption of debt. This capital was supposed to stay on BRK's books forever. However, after several years, BRK had to take an $11B write-down against the book value of PCC. The capital that was supposed to be permanent turned out not so permanent by a big margin.

While funds from investors on Owl's books are not required to get returned to investors, they still may be returned (under certain scenarios) or impaired. For example, in a deep recession, some loans may stop performing and will have to be written off reducing AUM and fees.

If something similar to the Financial Crisis strikes again, smaller private equity companies will perform miserably and many of them may cease to exist. Under these extreme circumstances, a big part of Owl's "permanent" capital will be wiped out together with related fees (though Owl's smaller RE segment is likely to remain unscathed!).

If the "business as usual" mode persists, Owl should grow fast accumulating permanent capital under management. I cannot guess its growth rate but any figure within the 20-40% range annually makes sense to me.

Valuations

The easiest way to value asset-light managers is by their yield as they typically pay out 80-90% of their cash flow. This is particularly true for Owl. To explain it, I need to dive deep into accounting - not the most exciting option. So I will spend only one paragraph on it which many may find undigestible and I apologize for it. You can easily skip the paragraph or ask me questions if super interested.

Differently from all other alt managers I am familiar with, Owl's GAAP statements are readable because Owl does not consolidate portfolio companies. These statements still have a lot of accounting noise from M&As (including the one that made Owl public), multiple classes of common stock (only Class A is trading publicly), and operating partnerships owned by Blue Owl, management, and some other parties (the top management holds only partnership units and the class of corporate shares that has voting control without economic value). If some expenses (like interest expense, for example) occur at the corporate level (which seems the case), then dividends on Class A common stock should be lower than distributions on partnership units (even disregarding different taxation). If we take into consideration only corporate dividends (instead of distributable earnings that are split disproportionately between the corporation and partnership), it will save us from the need to spend more time on accounting.

Under the dividend lens and assuming 20-40% growth, Owl seems undervalued. Comparison with other asset-light managers supports this conclusion:

ARES seems the best comp since "new" BAM has been trading publicly for less than two months and BX earnings include big contributions from performance fees and carry. Of all companies in the table, Owl is expected to grow the fastest.

The management expects the dividend to be $1 in 2025 vs $0.48 now. It implies doubling the stock in 3 years or 26% CAGR (even without multiples expansion) plus 4% in dividends.

Another possible valuation metric is Market Cap/FGAUM - it shows how much one dollar of FGAUM costs. The advantage of this metric is that BX becomes a valid comp.

Over years, this metric for BX was fluctuating from 0.12 (in 2018) to 0.24 in 2021 (i.e. the market values one dollar of BX's FGAUM from 12 to 24 cents). The average value is 0.16 with a 0.04 standard deviation. The current value is 0.16.

One dollar of Owl's FGAUM should be worth much more than BX's for two reasons: faster growth and permanent capital. This metric is currently equal to 0.21 and 0.16 for Owl and BX respectively. I am not sure this gap is big enough but cannot prove it.

Conclusion

With expected annual returns of ~30% over the next three years, Blue Owl Capital Inc. appears salivating. Perhaps, more promising than any other alt manager as long as we ignore risks.

Owl has two major risks that distinguish it from the Big Six. It has a very short history of public reporting and extremely high exposure to the private equity industry. I would also like it to simplify its corporate structure and have the management hold the same Class A shares that are traded publicly but I doubt it will happen.

All of the above invites caution. On the contrary, The Big Six successfully survived the Financial Crisis (Mr. Ostrover was watching it from the front seat while working for Blackstone); have enormous intangible assets such as human capital, a long track record of success, better diversification, and endless connections in different industries and institutions; and often enjoy secular tailwinds such as population aging for Apollo or switch to renewables for Brookfield. Weighing Owl's odds against the Big Six's is a rather delicate act.

Let us pose a direct question: how much one is supposed to allocate to Blue Owl Capital Inc. assuming she is committed to investing $100 in all alt managers?

There is no right or wrong answer here - it depends. Hinging on personal risk aversion, I guess any number in the range of $0-20 is appropriate. My preferable number is about $10. This number may grow if Blue Owl Capital Inc.'s RE business becomes comparatively bigger.

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