Onex Corp

TSX:ONEX

Earnings Call Transcript 2017-Q4

[Operator]

Welcome to Onex' Fourth Quarter and Full Year 2017 Conference Call. My name is Julianne, and I will be your operator today. [Operator Instructions] As a reminder, this conference is being recorded. I will now turn the conference over to Ms. Emilie Blouin, Director of Investor Relations at Onex. Please go ahead.

[Emilie Blouin]

Thank you, Julianne. Good morning, everyone, and 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.Our 2017 MD&A and consolidated financial statements are available on our website and have also been filed on SEDAR. Our supplemental information package, which includes the How We Are Invested schedule, schedules of 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 forward-looking statements disclaimer and need to point out that all information relating to the fair value of our private companies is the view of Onex management.In addition, later in this call, we'll reference various private offerings of securities, but we are required to remind you, these offerings are made solely to qualified institutional investors and to certain non-U.S. investors and private transactions not requiring registration under U.S. securities laws. The securities are not and will not be registered under U.S. securities laws and cannot be offered or sold in the U.S. without registration or exemption.Lastly, this year's Investor Day will take place in Toronto on June 14. Should you wish to attend, please contact me for more details.With that, I'll now turn the call over to Bobby.

[Robert M. Le Blanc, Senior Managing Director]

Thanks, Emilie, and good morning, everyone. I'll spend some time this morning reflecting on our 2017 performance and our activities so far this year. But first, let's take a look at what we're seeing in the markets.In the fourth quarter, the number of leveraged files completed and the amount of capital invested globally were up 7% and 19%, respectively, compared to the prior year. However, if we look at full year results, they were essentially flat year-over-year.We continue to see elevated valuations and record levels of dry powder chasing private equity deals. Although we don't know how long this will last, we remain disciplined in all types of markets to ensure we're sensibly transacting in this type of environment.Interest rates have moved up meaningfully over the last quarter but are still well below historical norms. Credit to fund leverage files remain readily available. However, if the recent volatility we have witnessed in the market continues, this could obviously change.The new U.S. tax policy does not seem to have had a material impact on the private equity industry. However, depending on the nature and financial profile of a business, there could be winners and losers under the new tax law. Businesses with maximum leverage and low capital expenditures will be most negatively impacted. This is particularly true for those that don't have enough pretax income to benefit from the lower corporate tax rate. We anticipate the impact on Onex to be neutral, with no major upside or downside within our portfolio.Let's now turn to some highlights of 2017. It was a particularly good year for Onex. We capitalized on the market conditions to return $3.5 billion to Onex and our partners, most notably through the successful sale of USI, the initial public offerings of JELD-WEN and Emerald, 2 secondaries for JELD-WEN and a partial sale of BBAM. Onex' share was approximately $1 billion, including $121 million of carried interest, our second best year ever for both realizations and carry.Since year-end, ONCAP reached an agreement to sell Mavis Discount Tire. Through this transaction, Mavis will be merged with Express Oil to create a leading operator in the automotive service sector. ONCAP also took Pinnacle public earlier this month, where we continue to hold a significant minority stake.We invested $1.4 billion in our private equity platforms over the course of 2017. Let's take a closer look at the investments we recently made: IntraPac, Laces Group and SMG Holdings.IntraPac is a designer and manufacturer of specialty rigid packaging solutions such as sticks, jars and closures. Our experience and knowledge of the packaging industry made us the preferred partner for management.Laces Group is a designer, manufacturer and marketer of bath accessories and home fashion products. Our knowledge of the business and competitive edge was enhanced by our ownership of Bradshaw and Hopkins.Lastly, SMG is a leading global manager of convention centers, stadiums and other venues. The company offers a comprehensive suite of services, allowing venue owners to outsource all facets of day-to-day operations such as facility, staffing and training and food and beverage service. We've been following the business for a long time, and it lives in the same ecosystem as Emerald.Not surprisingly, there are commonalities amongst these businesses that fit well with our investment philosophy. They each have experienced management teams who are investing alongside of us, good free cash flow characteristics and controllable levers that can help provide a clear thesis for value creation.With the acquisition of SMG, Onex Partners IV is now about 85% invested, which means we have room for one more acquisition before turning our attention to Fund V.Looking at our private equity portfolio as a whole, we own around 25 businesses that are in various stages of their value creation. As you know, we're focused on long-term results and not quarter-to-quarter changes. In 2017, the value of our private equity portfolio was up 18%. If we look at the last 5 years, it grew by 20% per year. This is right on target for us.We also raised our record amount of capital in 2017, including our recent $7.15 billion fund raise for Onex Partners V. Reflecting back on the fundraising environment, many GPs came to market to take advantage of the strong demand for private equity. This caused fundraising time lines to compress to an average of 13 months. For us, we were in and out of the market in 7 months and surpassed our original fund size target.About 90% of the capital in Onex Partners V came from existing LPs. We are also pleased to have some new investors and look forward to deepening our relationships with them in the coming years. Our fundraising success is a testament to the strength of our brand, our track record and our experienced and well-aligned management team.Turning to our credit platform, where we now manage almost $10 billion, having grown AUM by 30% last year. This was driven by 4 new CLOs and capital raise across our other credit strategies, including more than $300 million for our private debt fund. All of this activity contributes positively to our growing asset manager, which Chris will speak to shortly.Finally, one of the key pillars of our story is our team's meaningful personal investment in everything we do. Today, we have $2.1 billion invested in our shares, operating companies and credit platform. We believe this distinctive ownership culture creates strong alignment with our shareholders and limited partners.I'll now turn the call over to Chris to give an update on our balance sheet and our asset management business.

[Christopher A. Govan, Chief Financial Officer]

Thanks, Bobby, and good morning. My review of Onex' performance will focus on Q4. And as usual, I'll let our shareholder value model serve as the framework for my commentary. As a reminder, 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.Let's first look at our asset mix. Changes in our mix of assets are driven by Onex' net investment activity, both in private equity and credit. As you heard from Bobby, we closed on 2 new investments during Q4 through our ONCAP platform, IntraPac and Laces Group. Onex put $86 million of cash to work in these investments.Our private equity funds had another solid quarter of distributions, with Onex Corporation receiving almost $200 million from the underlying realizations, principally from a JELD-WEN secondary offering and the partial sale of BBAM.Activity in our credit platform in the quarter resulted in net investment by Onex of $13 million, mainly as a result of the first capital call from Onex Credit lending partners, our private debt fund.[indiscernible] aside, if you look back at our CLO investing over the course of full year 2017, you'd see that our net investment increased by about $100 million. This investment allowed Onex Credit to grow its AUM by nearly $2 billion. It's also important to note that the $100 million investment is net of $59 million of regular quarterly CLO distributions. And in fact, these distributions would have been about $6 million greater, if not for some upfront costs associated with the attractive refinancings and resets we completed. I point this out since I think these distributions are a source of recurring cash flow that often gets overlooked.Finally, Sky View, our last remaining Onex real estate investment, reached an important milestone. The project repaid all of its outstanding construction loans, which allowed it to begin making meaningful distributions to investors. Onex received $26 million during the quarter, bringing total distributions to $31 million for the year. We expect to receive regular distributions from this project as the balance of the condo units are sold. As a result of all of this activity, Onex' asset mix was almost unchanged in the quarter, with 71% of its capital invested at December 31.Next, I'll give you some detail around our investment returns by reviewing the quarter-over-quarter changes in the How We Are Invested schedule. Our PE funds generated a 3% quarterly return for Onex, which capped off a year in which Onex' private equity capital returned to 18%.Looking at the How We Are Invested schedule as a whole, Onex' Q4 hard NAV per share was $64.79, up 2% in the quarter and 11% for the full year, a solid year value creation for shareholders.My comments so far have focused on the almost $7 billion of capital that we invest on behalf of shareholders, but Onex shareholders also benefit from the $24 billion of capital we manage on behalf of fund investors. We expect the management of this third-party capital to provide a positive contribution to hard NAV growth over time or what we call operating leverage. And the schedule of fees and expenses that we publish quarterly provides one way of measuring Onex' operating leverage.Looking at this schedule, you'll see that our private equity platforms contributed $76 million in the year, up meaningfully from 2016. This improvement was driven by $121 million of carried interest realized in this year of significant high-quality monetizations. Partly offsetting the increase in realized carried interest was a $26 million increase in PE variable compensation.As we've explained before, lots of factors go into the determination of our PE team's variable compensation. But the greatest emphasis is placed on demonstrated value creation, and that typically corresponds with realization activity.The overall contribution from our asset management platforms, including the net overhead of the parent company, came in at $56 million, again, up meaningfully from the prior year. And remember, this positive contribution was achieved while managing Onex Corporation's capital fee free.Looking ahead, our run rate management fees work out to about $148 million, $98 million from PE and $50 million from credit. That's up 14% since the end of 2015. But you'll note that this run rate is actually down from last year, and that's because the impact of PE realizations, which reduce the base of capital in which we charge fees, was slightly greater than the benefit of additional fee-generating AUM raised in credit. However, the real story here is that we estimate run rate management fees will increase by roughly $48 million when fees begin to accrue from Onex Partners V. As Bobby noted, we're likely one new investment away from closing out OP IV.As a result, we're more confident than ever that management fees and carried interest will more than offset operating expenses over time, putting our shareholders in the enviable position of getting paid to have their capital managed by Onex.We believe Onex shares should reflect both the growth and the value of our investments and the growing contribution from managing fund investor capital. Over the past 5 years, our hard NAV per share has grown at a 10% CAGR, while our fee-generating AUM has grown 20% per year. Happily, as you can see from the slide, this performance translated into returns for our shareholders, with the stock compounding at 17% per year in U.S. dollars over the same 5-year period.That completes my comments. We'd now be happy to take any questions.

[Operator]

[Operator Instructions] Your first question comes from the line of Geoff Kwan with RBC Capital Markets.

[Geoffrey Kwan, Analyst]

Bobby, I know you talked a little bit about the environment right now of what's going on with a lot of dry powder out there and elevated valuations. I think on the last conference call, the comment was that the pipeline seemed kind of good. This was wondering if that's still a relevant comment. And then to the best you can use your crystal ball, forward looking a year from now, do you think Onex would more likely put more money to work relative to monetizations? Or might it be the opposite?

[Robert M. Le Blanc, Senior Managing Director]

Yes, we did make those comments last quarter and it remains true. We did manage to get 3 deals announced in Q4, which is great. The current pipeline is still decent. Things at various stages of their evolution, but it's -- the pipeline is good, and we just got to stick to our knitting and make sure we do the types of transactions we've always done.

[Geoffrey Kwan, Analyst]

Okay. And then you made a comment earlier about the impact of the U.S. tax reform not having an impact on the PE industry. Can you clarify like what aspect -- like where you talk whether or not it was deal flow or some sort of financial impact? And then also similar as an add-on to that question is, you talked about valuations being kind of elevated. Has that part of the market adjusted to the tax reform? In other words, for example, companies that might be more negatively impacted by the tax reform relative to others. Have those, call it, prices adjusted accordingly?

[Robert M. Le Blanc, Senior Managing Director]

I'll let Chris go back to his tax words and answer that one.

[Christopher A. Govan, Chief Financial Officer]

Yes, so I'll probably deal with the -- I'll call it, the micro aspect of that tax question. And I don't know whether Bobby or Seth or anyone else would have comments more macro -- from a macro perspective around the competitiveness of PE capital. But from a micro perspective and thinking about our portfolio maybe as a pretty good sample of your typical PE portfolio, we went through a fairly substantial process around year-end from 2 perspectives. One, all of our subs, obviously, had to prepare financial statements and audited financial statements and think through the impact of tax reform, generally speaking, on their deferred tax provisions and therefore, do a pretty thorough job of understanding the impact on them. And then separately, we actually redid, I'll call it, our valuation process for each of our portfolio companies after tax reform because our time line is that we typically do that before year-end. So we went back and revalued our entire portfolio, taking into consideration tax reform and importantly, the impact on any discounted cash flow models. And as Bobby intimated, really, when you go through that, there's some small winners and small losers in our portfolio, but no big ones. And on an overall basis, it kind of feels pretty much like a push when you look at our actual businesses in our portfolio.

[Robert M. Le Blanc, Senior Managing Director]

Yes, from a macro perspective, if you think about it, the businesses that I referred to, the ones that don't have a lot of CapEx, have high leverage and not a lot of pretax income. Their cost of capital relative to a long-term fund or a public company may be worse than it would have been otherwise without the tax reform.

[Geoffrey Kwan, Analyst]

Okay. But I mean for the stuff that you guys are looking at, do you feel like the -- any sort of seller expectations have properly adjusted for the U.S. tax reform? Or is there a sense that maybe they're trying to hold out for the valuation the company might have got before the tax reform came into place if they were the ones that would have been negatively impacted?

[Robert M. Le Blanc, Senior Managing Director]

No, I think the math and the impact on cash flows will be reflected in valuation for sure, for -- if this is -- have had a positive or negative impact relative to tax reform.

[Geoffrey Kwan, Analyst]

Okay. And if I can just sneak in one last question for you, Bobby. On the real estate side, obviously, you're talking about some of the existing investments that you're getting some distributions from. Is this an area that you might consider putting more money to work? And I know that there's, in the past, has been, and may still be the case, some of these U.S.-specific tax issues. Just wondering if there's an update on your thoughts or the company's thoughts looking at the sector.

[Robert M. Le Blanc, Senior Managing Director]

So yes, we've always sort of been looking at different asset managers in the real estate space. We haven't found one to date that fits in with our culture. If we find one, we'd be willing to do it. But it's not something that we're actively pursuing that you'll see us doing something in the next little while. But we have been looking for a few years now for something that makes sense. We just haven't been able to find something.

[Christopher A. Govan, Chief Financial Officer]

Yes. And I think just to address the tax part of that, I mean, I think you're right. From a tax perspective, real estate is less attractive to us than private equity capital. But I don't think that's a game -- like that's not a showstopper in terms of real estate platform not making sense for us. I just think it means that we'd have proportionately a smaller percentage of capital in a real estate platform than we do in our private equity platforms.

[Operator]

Your next question comes from the line of Scott Chan with Canaccord Genuity.

[Scott Chan]

I just want to clarify the last year-end, you -- for your year-end marks, you did incorporate the kind of the U.S. tax reform, lower taxes, and it's a net neutral value to your current portfolio. Is that what you're trying to get at?

[Christopher A. Govan, Chief Financial Officer]

Yes, that's exactly right, yes.

[Scott Chan]

Okay, okay. And if -- so if I look at this figure, you guys would take your target of 20% on your private investment in U.S. dollars, but you're not -- for sure, in U.S. dollars is up, 10%. So below that 15% target. Can you kind of remind me some of the key drivers of that kind of delta? And if you were to achieve that 50% target, assuming that you hit your 20% private equity returns over the next 5 years, what would have to happen to get to that target of 15%?

[Christopher A. Govan, Chief Financial Officer]

Yes. I think we kind of went through this at the last Investor Day or the one before that. But I think if you go back over the last 5 years, probably the greatest driver of the gap, if you will, would have been our cash balance over that period running ahead of the 25% target, which obviously converts what we hope is 20% returns into -- these days, into almost 0% returns. And as well, I think in the most recent time frame, because we report our results from our CLO investing on a mark-to-market basis, those returns on a mark-to-market basis haven't yet hit our hurdles that we're expecting from our CLO investing. But through the cycle, we -- as you know, we focus on cash flow there, and we still have an expectation and faith that the underlying models will prove out. So that's also been a small headwind in the most recent periods. It's a sort of the mark-to-market, I'll call it, performance of the CLO equity.

[Scott Chan]

So looking forward, it would be that kind of target mix. If there's excess cash, it would be kind of hard to hit that target going forward, I guess, is what you're trying to say?

[Christopher A. Govan, Chief Financial Officer]

Well, I think that's right unless our private equity portfolio outperforms that 20% target. And we obviously have had periods of times and cycles where we've done that. So the model is a target. And I think we're never, in any particular period, going to hit each of those targets exactly bang on, but that's what we're working towards. And depending upon the mix, we'll get the returns out the other side of that equation that it determines.

[Scott Chan]

And with the extra cash right now and your stock kind of underperforming recently lately, in terms of your NCIB, last year was a bit slower at 1.3 million. If I look out the last 4 years, it's averaged 3 million. Looking into this year, is more of an indication of the 3 million a better indication of what Onex plans to buy back through its NCIB?

[Christopher A. Govan, Chief Financial Officer]

We don't think of it that way, I'll say. We don't think of it going into a year in terms of a target, in terms of number of shares or dollars. We really do think about our Normal-Course Issuer Bid as an alternative use of capital. And so there's a lot of things that go into how active we are. Obviously, one of them is what opportunities we have near term to deploy that cash, either through our funds, through co-investments or through the growth of Onex Credit. That's a very big factor. And then the other will be how our stock's trading and the attractiveness of that purchase relative to the other alternatives we have near term. And then the last thing I'd say, and -- is that as you know, there are times when the stock's not trading in volumes that really allow us to buy meaningful numbers of shares and/or we can, from time to time, find ourselves in a position where we're blacked out and not able to be in the market. So you also have to be careful not to read too much into how many shares we buy back at any particular period in terms of that being an indication of anything on our part.

[Operator]

[Operator Instructions] Our next question comes from Paul Holden from CIBC.

[Paul David Holden]

So first question I want to ask is with respect to the markup on the private investments. We've seen some pretty healthy gains over the last couple of quarters. So just want to know on a high-level basis what's driving that. Because when I look at the portfolio investments, I don't see a lot of EBITDA growth, so I'm just wondering what the primary factors are.

[Christopher A. Govan, Chief Financial Officer]

Yes. So we can't talk about any specific marks, but we do mark our portfolio to market. And what that means every quarter, obviously, is looking at the broader equity markets and private equity markets. And one of the factors that impact valuation is where the rest of the equity markets are trading. That feeds into, obviously, those companies that we're marking based upon market multiples. And it also feeds into even the companies we're marking on a discounted cash flow basis because obviously, you have to assume an exit multiple. So that's certainly one factor. The other thing I'd say, and I think we've talked about this before is that because a lot of our investment thesis are active thesis, where we're actually doing things to improve a business and improve its value, there are sometimes milestone events behind the scene that you guys can't see in terms of us achieving certain cost savings that may not have shown up yet in EBITDA, added on certain businesses or acquisitions that we think position the company just -- be worth more than when we bought it. And so you can actually have sort of these step functions and value in some of our portfolio that actually might not correspond with broader changes in the equity markets. So it's hard to be very specific, but those are kind of some of the factors I'd point to over the last year.

[Paul David Holden]

That's helpful, I only wonder with sort of the high-level top-down perspective. So then my follow-up question would be given what we've seen in long rates post quarter end and some of the volatility in the equity market, how may that or may not impact your marks in Q1 or going forward?

[Christopher A. Govan, Chief Financial Officer]

Yes. So I mean, I'll be pretty high level again, I think. Obviously, I think if the equity markets trade off, you can expect that, that generally will be a negative towards our overall marks. There is a decent -- there's actually a decent part of our portfolio today that's actually publicly listed in the form of JELD-WEN and Emerald, in particular. But then there's also a decent part of our private portfolio that one of the fact -- that -- whose values are driven by market comparables. And so if we see the public markets trading off in terms of the multiples of those company -- the comparative companies, you can expect that to kind of flow through into our values. Now I would say, a decent part of our portfolio, the primary method of valuation is discounted cash flow. Again, partly because -- if I could take Save-A-Lot as an example, partly because we are often fundamentally changing a business. And during the time you're doing that, just blindly comparing or multiplying the company's EBITDA by some market comparable isn't really the right answer. So we do have a significant part of our portfolio that's valued on discounted cash flow basis. And in those cases, the impact of one quarter change in the public markets is going to be a lot more muted.

[Paul David Holden]

Yes. And I guess, that's why I asked on the yield side, what kind of impact does that have on your TCF calculations given interest rates have moved quite significantly and probably will move further through 2018?

[Christopher A. Govan, Chief Financial Officer]

Yes. So again, it has a negative impact. We, obviously, each quarter, look at our weighted average cost of capital, and that's forward-looking, not backward-looking. So you're right, that is sort of a negative headwind, if you will. Again, maybe I'll let some or other partners speak to this. But I think the other thing you get to take into account is why interest rates are increasing and why spreads are increasing. And if that's a sign of consumer confidence or a stronger economy, you might also see that playing out in terms of some stronger projections in some of our portfolio companies as well.

[Paul David Holden]

Got it. That makes sense. Okay. And then a couple more questions. Just curious to get a little more color around the 2 senior management appointments you've announced in 2018. So I guess, the first one around the Investor Relations and fund development, it's kind of interesting that part of that mandate is the development of new products across multiple alternative asset classes, so maybe you can elaborate on that point specifically.

[Emma Thompson]

It's Emma. Yes, so Tate has joined the team in the last couple of months. And as we said in the press release, the intention is for him working alongside me and others at the organization to think about natural extensions of our credit business in particular. So similar to the private debt strategy that we've launched, we'll be thinking about opportunities like that.

[Paul David Holden]

Okay, that's helpful. So it primarily will be related to the credit business is what you're saying?

[Emma Thompson]

Yes. But we will be also evaluating the market broadly to understand what else is out there, what investors are looking for and thinking about what might be a good fit for us.

[Robert M. Le Blanc, Senior Managing Director]

And with Nehal, she's been hired to run our capital markets group. She'll help our investment team think through different strategies around our capital structure from both the debt and equity side, and she'll be based in New York.

[Paul David Holden]

Okay. And on Nehal, as I think about that as an investor, as an analyst, are there going to be signposts where I'd be able to see that in some kind of financial metric, whether that's your cost of leverage or some other way?

[Robert M. Le Blanc, Senior Managing Director]

No, I don't think there's any you're going to measure. But I think what she'll bring to the table is making sure we get the best terms that are being offered in the market. And we're looking across the competitive landscape to see what other people are doing and making sure we're getting the right cost to borrow and the right flexibility around our debt. And then when it comes to equity, that will get the best execution. It's not going to be something that you -- that will be a line item that you're free to measure. But believe me, we vetted her off closely. We wouldn't have hired her if the nature has been creating a lot of value for us.

[Operator]

That concludes our question-and-answer session. I will now turn the conference back to Bobby Le Blanc.

[Robert M. Le Blanc, Senior Managing Director]

Thanks, everybody, for participating on this call. We appreciate your support. And as always, please feel free to call Emilie if you have any questions. I hope you all have a great weekend. Thanks.

[Operator]

This concludes today's conference call. You may now disconnect.