This week, I’m diving into one of the few SPACs from the 2020-era Lollapalooza in financial markets that has actually worked out: a fast-growing alternative asset manager humbly named Blue Owl that, perhaps, has its eyes set on being the next Blackstone?

At scale, the asset management business can have very, very attractive economics. A $10 billion private equity fund doesn’t necessarily require any more manpower or resources to operate than a $1 billion fund, yet the fees generated are 10x higher — talk about operating leverage.

As Blue Owl has ballooned from $45 billion to over $230 billion in assets under management (AUM) in just a few years, let’s see what’s going on with the underlying business.

— Shawn

Blue Owl Capital: Wall Street’s Rising Star

Three Business Pillars

Blue Owl’s diversified model, fueled by permanent capital commitments (91% of its fee-earning AUM), produces a steady stream of fee-related earnings. Unlike ETFs, where investors can withdraw funds at will, Blue Owl’s structures ensure capital stays put for years, if not indefinitely — a financial fortress.

Blue Owl is an alternative asset manager, meaning it specializes in strategies focused on private assets that you can’t invest in through a brokerage app, primarily accessible only to institutions and wealthy individuals, aka “accredited” investors.

There are three pillars underpinning Blue Owl, stemming from three separate firms that merged to form Blue Owl and now make up the core of its separate business units:

Pillar #1 — Private Credit (formerly known as Owl Rock): Provides loans directly to middle-market companies — those too big for traditional bank loans but too small for corporate bond markets (revenue size can range from $50 million up to $1 billion per year.)

Blue Owl’s niche is “direct lending,” which simplifies the process for companies that don’t want to deal with a web of syndicated loans from working with multiple banks. From a borrower’s perspective, having just one counterparty to renegotiate loan terms with is far more preferable, especially in times of crisis; imagine having to navigate pausing repayments during pandemic lockdowns with 20 different banks instead of working with just Blue Owl.

This is often synonymous with private equity, as private credit firms provide loans to finance buyouts.

Pillar #2 — GP Capital Solutions (formerly known as Dyal Capital): Acquires minority stakes in the firms that run private equity funds, as well as hedge funds, sharing in their management fee revenue.

Founded and led by billionaire Michael Rees, Dyal set new precedents on Wall Street by helping “general partners” cash out parts of their ownership stakes in their own investment funds, giving them payouts that they could keep for themselves or use to seed their investment funds with.

Pillar #3 — Oak Street (Real Estate): Specializes in triple-net-lease properties, where tenants cover property taxes, insurance, maintenance, and rent. In particular, this unit focuses on “lease-back financing” — they buy warehouses, data centers, offices, and other properties from companies who want to offload real estate assets from their balance sheet, and then Oak Street enters into triple-net-lease agreements to lease the properties right back to those companies.

In other words, companies transfer their commercial-property assets to Blue Owl in exchange for cash but continue to use those properties by leasing them instead.

Its crown jewel property is Calgary’s second-largest skyscraper, The Bow.

SPAC Origins

Like so many other SPACs exploiting the frothy markets at this time, Blue Owl debuted as a merged, publicly-traded company in late 2020.

Yet, this wasn’t your typical SPAC gamble. The merger combined two heavyweights— Owl Rock and Dyal Capital — and later incorporated Oak Street, spawning a rather robust alternative asset business.

Today, as outlined above, Blue Owl’s assets span private credit, infrastructure, commercial real estate, stakes in private equity firms, and even minority ownership of pro sports teams, and the company continues to expand aggressively, recently acquiring smaller asset managers like Kuvare Asset Management and Atalaya Capital to bolster its AUM.

With $21.7 billion in undeployed cash set to generate $260 million in incremental annual management fees and more acquisitions likely looming, Blue Owl’s trajectory looks promising.

But rapid growth begets questions: Are they overpaying for acquisitions? Will the structural tailwinds of more and more money flowing into private assets reverse? Will alternative asset managers eventually have to aggressively trim fees as mutual funds in public markets have had to in response to Vanguard’s passive-investing revolution?

Don’t Trust a Gold Rush

The private credit and alternative asset industry at large is booming. Like, seriously booming. It is, arguably, one of the biggest trends in finance following the ‘08 crisis.

Private equity strategies, closely tied to private credit, have more than tripled their AUM since 2010 and are expected to double again by 2029.

That influx of capital into private assets, chasing the so-called “illiquidity premium” (a financial theory suggesting less liquid assets should offer higher returns to induce investment), has surely caused that same premium to diminish as the illiquid become liquid, resulting in returns that increasingly resemble public market counterparts on average yet with higher fees that consume any residual outperformance.

At least, that’s what the skeptics say, and I’m probably closer to skeptic than optimist when it comes to the infatuation with private assets.

A recent Ohio State study found just this, highlighting that private credit’s supposed “excess returns” are largely neutralized by higher fees. If investors grow disillusioned, Blue Owl could find itself competing for new assets by cutting fees in a race to the bottom amongst alternative asset managers broadly.

On the flip side, Blue Owl’s permanent capital base offers stability. Much of its AUM is tied up in business development companies (similar to private-market versions of closed-end funds) and other vehicles with long-term lock-ups on capital, which is an ideal position for any asset manager to be in.

And with some true industry veterans leading Blue Owl, including Doug Ostrover, Michael Rees, and Marc Zahr, there’s no lack of talent and experience at the company.

The thesis for Blue Owl, though, boils down to your outlook on alternative assets.

Grossly generalizing here, but you might either see alternatives’ popularity as a bonanza in laundering volatility (simply hiding fluctuations in private assets’ value by not marking them to market daily) and using leverage that amplifies returns but also risks, or you see legitimate financial solutions being delivered that continue to offer attractive return and diversification benefits to a range of investors.

The answer, as always, is somewhere in between, but which way you tilt toward will shape whether you think the alternative asset industry will continue to grow as expected, how well you think it will hold up in a downturn, and whether you think the considerably higher fees charged by these strategies are sustainable.

When talking about a $230-billion+ asset manager, the macro matters considerably more than for your typical value-investment pick.

Dizzying Corporate Structure

Due to its acquisitive nature, frequently funding purchases of smaller asset managers with new issuances of its own stock, and from its SPAC-merger genesis, trying to understand Blue Owl’s corporate structure is enough to make one’s head spin.

I have never wanted to pull my hair out more when studying a company than with Blue Owl, whose filings are littered with dense Wall Street jargon, legalese, and seemingly endless layers of subsidiaries and cross-ownership.

For as exciting as Blue Owl’s ascendance has been — soaking up permanent AUM with a litany of novel alternative asset strategies while boasting 40% free cash flow margins, trying to understand what you’re actually investing in is enough to give anyone pause.

For starters, when you look up Blue Owl’s stock, what you’re seeing is the price for its class A shares, though it has four different share classes (A, B, C, and D.) And when you look at the company on different financial data platforms, you’ll see that some calculate its market cap differently: Some will report the company as having an approximately $14 billion market cap, and others will report an approximately $38 billion market cap.

So which is it? Well, both, kind of. The entire enterprise, known as the Blue Owl Operating Partnership, is the latter larger valuation. But technically, the class A shares, which again are the only ones that trade publicly, own a 39% stake in the Operating Partnership (hence the $14 billion valuation — 39% * $38 billion.)

Confused yet?

To spare you a bunch of caveats and nuances, the easiest explanation is that you must account for all the different share classes.

They’re all equal in terms of economic ownership of the business’s earnings but differ in that certain classes have more voting rights and stem from either internal compensation packages or from past mergers & acquisitions, such as with Neuberger Berman’s large holding of special C-class shares awarded in return for allowing Dyal Capital to merge with Owl Rock through a SPAC to form Blue Owl back in 2020.

Ultimately, though, for the class C or class D shares to be sold, as executives, employees, and third parties like Neuberger Berman cash out their holdings, the shares must be converted to class A shares — increasing the number of A shares and correspondingly decreasing the number of C/D shares (there are no B shares currently.)

Over time, then, the other share classes will mostly or entirely become A shares and grow the A shares’ claim on the Operating Partnership from 39% to as much as 100%. That act of converting other share classes to A shares isn’t necessarily dilutive, but future increases in total shares outstanding (counting all share classes) to compensate management or fund acquisitions are potentially dilutive.

The reason I drag you through this is to hit home the point that you shouldn’t make the mistake I made when first studying the company, thinking the entire company’s free cash flows could be attributed to the A shares, which makes the cash flow per share look considerably higher than it is.

You need to account for all share classes (larger denominator) or adjust cash flow per share to reflect that 2/5 belong to the class A shareholders (smaller numerator.)

To save you the trouble: Blue Owl’s valuation is roughly 40x free cash flow, not 16x, which doesn’t exactly make it cheap, but “cheap” is subjective. If Blue Owl can continue to rapidly grow AUM through acquisition, assuming the acquisitions are made at attractive prices, 40x FCF may look like a bargain in hindsight.

Also, note that I focus on cash flows because Blue Owl’s reported net income is considerably suppressed by non-cash charges that stem from charges for depreciation and amortization tied to M&A activity and stock-based compensation.

Valuation

This is daunting. Financial services firms are notoriously difficult to value because there’s no good way to audit the quality of their assets. Sure, I know about some of the assets Blue Owl’s investment funds own, but there’s not enough time, nor is the information available to vet its more than $200 billion worth of capital allocations.

I’m hoping that it’s mostly in high-quality real estate and loaned to companies that will be able to repay debts in a recession, but all we can really do is go off the track records of these funds and have faith in management.

With Vital Farms, in contrast, I could confidently know A) which types of farms they work with, B) the facility where they distribute the eggs from, and C) the grocery stores they ship the eggs to, rounding out the core of its operations. Infamously, though, financial services firms are operational black boxes.

Look no further than the 2008 Financial Crisis to see what I mean.

To be clear, Blue Owl isn’t a bank, and I have no reason to think they aren’t a very well-run asset manager, but I want to emphasize that there’s an extra degree of uncertainty with financial services given the vast amount of financial assets and leverage involved (Blue Owl borrows at both the parent company level and within its individual funds.)

Investing in a financial services business is a massive bet on management and culture, hoping, in Blue Owl’s case, that, at every level, the business is well run. That the right talent is being attracted and incentivized in ways that align with management, that the AUM is being responsibly allocated, that the capital is truly as permanent as management says it is, that clients will continue to be attracted to the strategies they offer (i.e., private assets generally), and that excessive leverage isn’t being employed in hidden ways.

A lot of accounting and risk-taking chicanery can happen with financial services businesses, a lesson that Buffet has now learned twice, with Salomon Brothers and, more recently, with Wells Fargo.

I already know that Blue Owl isn’t the type of company I want to own, so I’m not going to torture myself with building a model and deriving an intrinsic value target.

Laziness? Perhaps, but why waste time valuing a business I’ll never feel comfortable owning as an outside observer, given the opportunity costs of not spending that time digging into other wonderful and understandable businesses?

With a 3% dividend yield at current prices and a 40x FCF valuation, I’m content with concluding that the business is probably fairly valued. After all, Wall Street should be able to understand and value this business better than anyone. I don’t see enough from an expected growth point-of-view or valuation perspective that makes me want to dig in beyond what I’ve already learned qualitatively about it.

Conclusion

To recap, here’s why I’m passing on Blue Owl, despite some musing it might be the “next Blackstone”:

Alternative Asset Boom Turning From Tailwind to Headwind: I have major concerns about the rise of alternative assets, and I’m not sure it’s as sustainable as others think. As more capital flows into private equity, for example, the more valuations will be bid up, and the more forward returns will resemble public-market norms, without even mentioning that one of the most attractive “diversifying” features of private assets is a mirage (that they don’t have much volatility because they aren’t priced daily like publicly-traded stocks and bonds.)

The same is true in private credit; with more private credit lenders, borrowers will have more negotiating power to demand lower rates or more favorable terms coming at the expense of returns for investors in private credit funds. I also wonder if, with such high fees, many of these strategies can continue to attract new AUM over the next 5, 10, and 20 years without dramatically cutting management fees.

Besides the stickiness of their existing AUM, it’s not clear what the enduring ‘moat’ is here.

Overpriced Acquisition Concerns: Additionally, there’s a lot of competition in the alternative asset management space with giants like KKR, Apollo, Blackstone, and Ares, and it’s not clear to me that, even though Blue Owl is growing quickly, it’s being done so economically for shareholders. Blue Owl has done a good bit of M&A, but if the smaller firms they’re acquiring are such great businesses or are selling themselves on the cheap, how come these larger asset managers aren’t outbidding Blue Owl for them?

Management/Valuation/Culture Uncertainty: As mentioned, financial services firms are hard to value, and a significant amount of trust must be placed in top, middle, and lower-level management since things can quickly go south (see Saloman and Wells Fargo.) My impression is that the team at the top of Blue Owl is well-respected, but I don’t work on Wall Street or as a financial advisor, so I have very limited firsthand exposure to the business.

Thus, I’m passing on Blue Owl. But I’m glad I studied it. I learned a good deal about asset management businesses, private assets, and corporate structuring (sigh), and that knowledge will hopefully pay dividends down the road. To go deeper into Blue Owl and the alternative asset management industry, check out my podcast on the company here.

I’ll be back next week with another prospective investment for The Intrinsic Value Portfolio.

Weekly Update: The Intrinsic Value Portfolio

Notes

• No new additions to Ulta; Alphabet stock has continued to decline, which I used as a chance to increase its position by 1 percentage point, bringing the average share cost down to $185 per share.
  

• AutoZone and VeriSign both remain above my price targets, so they haven’t been added to the portfolio

Quote of the Day

"An investor who has all the answers doesn’t even understand the questions. Success is a process of continually seeking answers to new questions.”

—John Templeton

What Else I’m Into

📺 WATCH: Steve Cohen on how to build your investment career

🎧 LISTEN: How to invest during fiscal dominance with Lyn Alden

📖 READ: Berkshire Hathaway’s 2024 shareholder letter

Your Thoughts

Here’s what readers had to say about VeriSign last week:

• “Thanks Shawn, great company with a moat, but not for me, looking for more attractive growers.”
  

• “Really enjoying these deep dives into specific companies! I mainly invest in real estate and index funds, but I look forward to applying the analysis learned through your newsletter to buy individual stocks someday - or at least help inform strategies for running my small business.”

See you next time!

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