Onex Corp

TSX:ONEX

Earnings Call Transcript 2018-Q2

[Operator]

Welcome to Onex' Second Quarter 2018 Conference call. My name is Daniel, and I will be your operator today. [Operator Instructions] As a reminder, this conference call is being recorded.I will now turn the conference over to Ms. Emilie Blouin, Director, Investor Relations at Onex. Please go ahead.

[Emilie Blouin]

Thank you, Daniel. Good morning, everyone. Thanks for joining us. We're broadcasting this call live on our website. With me today are Bobby Le Blanc, Chris Govan and a number of our managing directors.Earlier this morning, we issued our second quarter press release, MD&A and consolidated financial statements, which are available on the Shareholders section of our website and have also been filed on SEDAR. Our supplemental information package, which includes the How We Are Invested schedule, schedule of the fees and expenses and additional information is also available on our website.Before we get started, just a reminder that all references to dollar amounts on this call are in U.S. unless otherwise stated. I must also remind everyone of the usual disclaimer relating to any forward-looking statements contained in today's presentation and remarks. Please refer to our webcast presentation for cautionary factors related to these statements.With that, I'll now turn the call over to Bobby.

[Robert M. Le Blanc, Senior Managing Director]

Thanks, Emilie. Good morning, everyone. I'll start as usual with an update on what we're seeing in the markets, followed by commentary on our activity in the second quarter and some developments since then.The private equity industry remains very active. We have recently seen a few big LBOs announced that will have sizable financing in the market post Labor Day. This is coming off an already busy period that topped out ahead of July 4, with $73 billion of loans pricing in June, 2/3 of which were for acquisition financings. As a result, we saw the cost of borrow rise in that period for the private equity industry. To give you an example, in June, a quality LBO would have priced as first-lien debt in the LIBOR plus 325 range. Today, it would come to market around LIBOR plus 375, and for a larger-sized transaction up to LIBOR plus 400 to 425. This is on top of a pretty big move for LIBOR, which has increased by 65 basis points this year and currently stands at 2.3%. Not surprisingly, there have been fewer repricings done in July, given the option value of the additional supply coming to market and the general widening of rates. Interestingly, we have not seen the higher cost of borrow reflected in the price buyers are willing to pay for businesses, which tells us equity returns are being underwritten at lower yields in many instances.In the face of this difficult market environment, we remain focused on finding investments with controllable levers, where we hope to create long-term value for our investors. On that note, year-to-date, we've invested or committed to invest approximately $1.8 billion in 5 operating companies. Let's take a closer look at our most recent investments. KidsFoundation, Precision Global and Ryan Specialty Group. KidsFoundation is the largest and one of the highest-rated child care providers in The Netherlands. We have researched this industry for about 2 years and diligent several opportunities in the Dutch market broadly. In addition, we built a strong relationship with the company's management team throughout the diligence process, and our conservative use of leverage made us their preferred partner. Our thesis is to build on the current platform organically and via acquisition, both domestically and internationally. Precision Global is a leading global manufacturer of dispensing solution, such as aerosol valves, actuators and pumps. Our experience investing in the packaging industry, historical knowledge of the company itself and current ownership of Davis-Standard, IntraPac and SIG, all resonate with the management team. Our passive value creation will include organic growth, add-on acquisitions and operational improvements.Finally, Ryan Specialty Group, or RSG, is a leading international specialty insurance broker. We've known the founder, Pat Ryan, for more than a decade as he was the Chairman of Aon when we carved out the Warranty Group in 2006. As well one of RSG's largest customers is USI, another business we owned recently. So we understand the value proposition the company brings to its clients. The capital we invested is earmarked to accelerate the company's organic growth and M&A activity. All 3 of these businesses are market leaders in their sectors, with strong management, attractive growth prospects and controllable levers that help provide a clear thesis for value creation.On the realization front, we've returned about $865 million to our partners, primarily from the sale of Mavis Discount Tire and the secondary share sales of Emerald Expositions and Pinnacle.Looking at our private equity portfolio, our performance was mixed during the quarter. While many of our businesses were ahead of last year, a few are not yet producing the results we've underwritten. That said, in some instances, this is largely a matter of timing. For example, in the case of Save-A-Lot, the company is going through a planned transition. Although we don't typically delve into specific company performance, it's worth providing some context here in detail on our value-creation opportunities to come. In 2016, we acquired Save-A-Lot, a limited assortment grocery retailer in the U.S. from SUPERVALU. This acquisition was a corporate carve-out and planned to be a major transformation, which required us to invest meaningfully in talent and systems as part of creating a stand-alone company. This has taken time and patience. Earnings were impacted more in this initial period than we underwrote during our due diligence. However, our investment was never about what happens in the short term and all about what we can do with the company over the course of our ownership.To that end, we now have our new CEO, Kenneth McGrath, leading the business and have upgraded most of the senior leadership to create a world-class team. We've also recruited new independent Board of Directors. With the team in place, we'll implement the first stage of our commercial transformation plan this fall, which is focused on improving the company's value proposition and the customer experience. We're excited to be moving into this next phase with Save-A-Lot, which will run in stages over the next few years. Overall, we feel good about the businesses we own. Of course, there will be some quarters and years that are better than others. But with controlling interest, we have the ability to affect change and create value over the long term. Today, we're diversified across more than 30 companies that operate in a wide range of industries. It's worth highlighting that more than 40% of our private equity portfolio was invested in just the last 2 years and 2/3 of it in the last 3 years. Given that many of our businesses are in the early part of their investment thesis, we are optimistic that our private equity portfolio will ultimately generate attractive returns.Turning to our credit platforms, where we now manage about $10.5 billion. Our assets under management increased nearly 10% this year, mainly driven by our 15th U.S. CLO, which we closed in June. Finally, one of the key pillars of our story is our team's meaningful personal investment in everything we do. In total, we have $2.1 billion invested in our shares, operating companies and credit platform, including $100 million invested so far this year. This financial alignment is critical to our culture and overall success. We all share in the risks and rewards of everything we own.I'll now turn the call over to Chris to give an update on our balance sheet and the asset management business.

[Christopher A. Govan, Chief Financial Officer]

Thanks, Bobby, and good morning, everyone. As usual, I'll review Onex' quarterly performance relative to our shareholder value model. And I remind you, in that model we target being about 75% invested, earning blended returns from private equity and credit in the high-teens and generating positive operating leverage from our asset management platforms.I'll start by reviewing our current asset mix, the first driver of our performance. Changes in our asset mix are driven by Onex' net investment activity, both in private equity and credit. In private equity, we put $172 million to work in Q2, with the investment in RSG. Net of some smaller realizations and combined with continued steady growth of credit, Onex ended the quarter with 77% of its capital invested, slightly ahead of our 75% target. Our PE platforms were busy committing and investing capital subsequent to quarter-end. We closed on our investments in PowerSchool and Precision Global earlier this month putting over $300 million of Onex capital to work. If you adjust our asset mix for these investments, and the pending KidsFoundation acquisition, Onex moves to 83% invested on a pro forma basis, a level that positions us for stronger growth and hard NAV going forward.On to the next driver, investment returns, which I'll get at by reviewing the quarter-over-quarter changes in the How We Are Invested schedule. Onex' overall investment in PE didn't change much in the quarter with fairly flat returns of 2%. On an LTM basis, our PE returns were 9% moving our 5-year compound returns to 17%. Looking at the schedule as a whole, Onex' Q2 hard NAV per share was $64.59, up 1% since Q1 and 4% in the last 12 months, both of which reflect the relatively muted returns from our PE investments.In Canadian dollars, hard NAV per share was $85.05, up 3% in the quarter largely due to a stronger U.S. dollar.I'll shift now and discuss our asset management business, the last component of our shareholder value model. We expect the management of nearly $25 billion of third-party capital to provide a positive contribution to the NAV growth over time, or what we call operating leverage. I like using a schedule of fees expenses to explain our operating leverage.Turning to that schedule, you'll see that LTM private equity fees were $98 million, down from $105 million in calendar 2017. That decrease was attributable to realizations over the last 18 months, which reduced the base on which fees are earned in our older funds. Looking forward, and all other things being equal, we expect our run rate PE fees to increase to approximately $150 million, once OP V becomes active. So what you're really seeing here is an LTM period where the PE platform's management fees are at a trough and carried interest is meaningfully below our 5-year average, yet the PE platform still contributed $12 million and that's without any fees being charged on the Onex corporation capital it manages.At credit, the consistent growth in its contribution continued, $22 million in the LTM period, up $2 million from calendar '17 and with $52 million of run rate fees, there's $5 million of top line growth still to come based on the assets we've already raised. Obviously, credit plans to continue to raise additional assets going forward, both at its existing CLO platform and through new distribution channels and products built around its core senior loan franchise.I like to end with this slide because it explains Onex' performance in simple terms. Two of the lines show you our performance against our 2 key goals, growing both our hard NAV per share and our fee-generating AUM. Not surprisingly, the third line, the corresponding growth in our share price, shakes out in the middle, reflecting a 10% CAGR over the last 5 years. We'll keep focused on growing both our NAV and AUM, confident that our stock will reflect our overall performance. That completes my comments. We now would be happy to take any questions.

[Operator]

[Operator Instructions] Our first question comes from Geoff Kwan with RBC Capital Markets.

[Geoffrey Kwan, Analyst]

First question was for Chris. So on the $150 million run rate on the management fees versus the $97 million now, how much of that delta, call it the $53 million, would there be some sort of compensation that it gets allocated to? I'm just trying to figure out what might be the net -- how to think about the net increase?

[Christopher A. Govan, Chief Financial Officer]

So Geoff, I think that, as you know, we're always looking forward when we think about our team and our investment capabilities. So I think there's always an expectation that we're going to grow over time. But having said that, I think we believe our team is in place and positioned to invest OP V over its commitment period and certainly, our limited partners believe that, hence the commitment. So I really don't think of there being incremental costs or compensation actually tied in any direct way to that fee increase.

[Geoffrey Kwan, Analyst]

So I guess to which your point is that most of it would fall to the bottom line, so to speak, as opposed to on, I think, on the overall level like the comp ratio is usually sometimes around, call it, 60-ish percent give or take? Is that the right way to think about it?

[Christopher A. Govan, Chief Financial Officer]

Yes. I think that's the right way to think about it. We don't -- we're not your typical investment bank where we have a bonus pool set upon some percentage of gross fees. We pay our team market, and we think we've got a team in place that's the right size and right skill set to invest OP V. So I think any growth you sort of see in team compensation over the next 5 years will really be about us growing our team in anticipation of potentially a bigger OP VI and a bigger Onex balance sheet to invest.

[Geoffrey Kwan, Analyst]

Thanks for that. My second question was, if I remember correctly, when you make a new investment, you typically don't markup the value within the first year. And so, therefore, you may get, call it the 1-year anniversary or thereabouts, maybe a little bit of evaluation bump. Is that correct? Just I am trying to think about in the context, because I think over the past year you've put to work about $800 million of your own capital.

[Christopher A. Govan, Chief Financial Officer]

Yes. So Geoff, I wouldn't characterize that as the hard and fast rule. I mean, things can, obviously, drastically change shortly after you acquire an investment, that's possible. But for the most part, if you kind of think about the way we buy businesses and what we're trying to do with them, it's not very often that in the first year when we sort of reflect upon the performance of the financial metrics and the comps out there that you see material adjustments to our marks. There is nothing also magical about the 1-year point either. But I would agree with you that we -- marks don't tend to move very much in the first 12 months.

[Geoffrey Kwan, Analyst]

Okay. I know you, obviously, can't talk about the specific stuff that you may or may not be doing. But you've talked a little bit before about -- on acquisitions, but how about on divestiture side. Are there certain assets, if we're looking out over the next 12 to 18 months, that you think there may be some part or parts of the portfolio that may get monetized in some way?

[Robert M. Le Blanc, Senior Managing Director]

Geoff, it's Bobby. Like obviously, we were constantly looking at our portfolio and discussing and debating what we want to hold versus sell at any point in time, but we can't comment on any specifics.

[Geoffrey Kwan, Analyst]

Okay. And very last question. Just given all this talk and the news with the whole Canada-Saudi Arabia thing, is there anything that we should be aware of from, say from a LP investor standpoint exposure to the Middle East? And any potential implications that we should be thinking about?

[Robert M. Le Blanc, Senior Managing Director]

We have no exposure that we know of.

[Operator]

And our next question comes from Paul Holden with CIBC.

[Paul David Holden]

So first question is maybe you can just remind us when fees on OP V might become active? What the key trigger is and when we might hit that? Given the recent investments, I assume that could be soon.

[Christopher A. Govan, Chief Financial Officer]

Paul, so the trigger basically is the sort of the first investment or first capital call from OP V. In terms of timing, you're right, it depends upon investment activity. We're about 90% called, invested at OP V. We want to partly and mainly because our LP wants us to get that fund as fully invested as possible. There is lots of variables that go into how much capital we want to retain and hold back for potential add-on investments, and we're constantly assessing that. But at the moment, we'd be of the view that there is room for one more decent size deal in OP V. Excuse me, in OP IV.

[Paul David Holden]

Okay. Got it. That's helpful. And then as we look at your reported PE returns over the last 12 months, 9% and I realize that's never going to be a straight line number, but that is significantly below sort of the long-term average. So maybe you can just kind of talk about some of the factors that have contributed to the below average returns over the last year?

[Robert M. Le Blanc, Senior Managing Director]

Yes. Clearly, the 9% is well below our 5-year average. Again, remember, our portfolio is relatively new. We've invested almost 2/3 of our PE dollars in the last 2 years, and things like PowerSchool, Precision and Ryan aren't even in these numbers. We've just deployed those -- that money recently. But look, we're on it. There are certain companies where -- like Save-A-Lot, as I described. The plan is intact. It's going a little bit slower than we liked, and there's examples of that across the portfolio. But where we are looking at over the longer-term view, and we like the businesses we own, and we hope the results over an appropriate longer period of time will reflect that.

[Paul David Holden]

Okay. Fair. And then final question. I think I probably ask you a question about Trump policy every quarter, when I ask one more. Are tariffs that have been announced impacting any of your businesses, whether negatively, neutral or positive?

[Robert M. Le Blanc, Senior Managing Director]

So I had a feeling you were going to ask that question. We actually prepared it. When we look at Onex overall, our dollar exposure to revenue in China is relatively small. So there's nothing material for Onex. We have 2 or 3 businesses that have 10% or more of their revenue coming out of China. And obviously, we don't understand exactly how these tariffs will impact it, if they're actually enacted. But we're on it at the portfolio company level. But as a major issue for Onex itself, I don't think it's a big issue.

[Operator]

[Operator Instructions] Our next question comes from Scott Chan with Canaccord Genuity.

[Scott Chan]

Chris, just appreciate the pro forma on the recent investment and the cash position at 17%. I know your target is 25% medium term. And maybe to go about the question the other way in terms of potential disposition, do you expect to operate at a cash level that's under 25% over the next few years, or do you expect that to significantly swing? Or how should we think about that?

[Christopher A. Govan, Chief Financial Officer]

Yes. I mean, you, obviously, sort of your caveats in an important way. I mean, it's so dependent upon realizations, which obviously are difficult to predict. We manage our capital conservatively. We don't factor in maybes around realizations when we think about our commitments and the need to be in a position to fund opportunities when they arise. So we're still very comfortable with our cash position at 17% that we've got enough dry powder to take advantage of what's in front of us. But I really can't predict whether we're going to be under 25% for a long period of time because there's a lot of factors that go into whether or not we decide to launch sale processes and whether those are successful. But if we're going to hit 25% through cycle, there needs to be periods of time when we're running under 25%. So it's certainly not a bad thing.

[Scott Chan]

And if I look at the 17% right now, does that impact in near term kind of the ability on buybacks that you guys have been pretty consistent about over the last 3, 4 years?

[Christopher A. Govan, Chief Financial Officer]

I don't believe so. I mean, 17% might sound small, but it's over $1 billion and that leaves plenty of room, I think, if we believe that there is a good opportunity in buying back our stock relative to what we see on our deal log coming down the pipe to act on that.

[Operator]

[Operator Instructions] And that concludes our question-and-answer session. I would now like to turn the call back over to Bobby Le Blanc for any closing remarks.

[Robert M. Le Blanc, Senior Managing Director]

Thank you very much, everyone, for joining the call. And we hope you enjoy the rest of your summer. If you have any questions, feel free to reach out to Emma or Emilie. Take care.

[Operator]

Ladies and gentlemen, thank you for participating in today's conference. This does conclude today's program, and you may all disconnect. Everyone, have a wonderful day.