September 12, 2018 | James Sprow | Blue Vault
For Financial Professional Use Only. Not for Retail Clients.
3 Part Series, see links to BlueVault Research to see links.
At a time when annual sales of nontraded BDCs have fallen from $6 billion four years ago to less than $1 billion by the end of 2017, Owl Rock Capital Partners has been able to buck the trend. With the launches of Owl Rock Capital Corporation (“ORCC”), a private BDC, and Owl Rock Capital Corporation II (“ORCC II”) a nontraded BDC program, the firm has succeeded in raising capital from institutional and individual investors at a rate that far exceeds any other BDC manager. ORCC, launched in early 2016, raised $5.5 billion of equity commitments from institutional investors such as the State of New Jersey Common Pension Fund, Brown University and MSD Private Capital Investments (the family office of Michael Dell), and through wealth management platforms like Merrill Lynch and Ameriprise. ORCC II launched in April 2017 and, as of August 31st, has raised $300 million since inception, and accounted for almost 75% of the equity capital raised in the sector year-to-date. How do we explain the success of Owl Rock occurring within a downward trend for the industry as a whole? According to observers, Owl Rock’s success has much to do with the alignment of interests and revisions to its fee structure.
Owl Rock has tested the concept of raising capital through the retail channel with a lower or non-existent up-front commission. The way it works is for advisor firms to select their own pricing models instead of the once-standard 10% sales load. Owl Rock absorbs most of the costs and takes a long-term view of their own profitability. Thus far, all of the capital raised was at a cost to shareholders of 5% or less, which is half the cost of legacy non-traded funds. Further, Owl Rock took the step to lower its management and incentive fees from the once standard 2% and 20% model to 1.5% and 17.5%.
Second, Owl Rock has moved away from the advisor/sub-advisor structure where an institutional manager hires or partners with a distribution firm to co-manage the fund, which was the hallmark of the initial wave of non-traded BDCs. As a manager of institutional capital with a captive distribution team, Owl Rock can better manage costs and ensure that individual investors are afforded the same investment opportunities as institutional investors, which will hopefully result in better investment outcomes.
Another important feature of ORCC II is the lack of a distribution servicing fee. This is a common cost added to other non-traded BDCs and REITs and has historically eroded distribution yields. By not charging this fee, ORCC II allows investors to retain more of their distribution income and it also makes ORCC II eligible to be purchased in advisory accounts.
The Private Credit Market Environment
The rapid growth of the private credit arena that Owl Rock has entered and succeeded in has been driven by the phenomenon of bank retrenchment, particularly from middle market corporate lending. Privately focused lending groups such as Owl Rock have filled the void left by banks. There is also the attractiveness of BDCs from a governance perspective as they must file with the SEC and have majority-independent boards. From a risk management perspective, the strategy of using floating rate loans that benefit from higher cash coupons when rates rise protects investors from interest rate risk. Risk is also mitigated by investing in more senior parts of the capital structure as well as having stronger protections and loan documentation compared to debt syndications in the public high yield or leveraged loan markets.
As a result, private credit funds have become increasingly attractive to sovereign wealth funds. The average allocation to alternative credit is at 4 percent and increases to 5 percent among the largest sovereign funds with more than $25 billion of AUM. Public pension funds are investing in BDC structures as they look for efficient ways to get exposure to the private credit and direct lending market. Assets under management in the private debt space hit $638 billion through June, according to Preqin and 42% of institutional investors plan to invest more capital than last year in the space.
While institutional investors have largely accepted the need to increase their allocations to alternative investments such as real estate and private credit, individual investors are still relatively under-allocated to alternatives. This can be partially attributed to the high fees associated with predecessor programs. With innovative programs such as Owl Rock Capital Corporation II, individuals now have an opportunity to invest with low or no upfront loads in portfolios that are run by the same high-quality managers who invest on behalf of large institutions.