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Fitch Downgrades Och-Ziff Capital Management Group LLC to 'BB-'; Maintains Negative Watch
February 23, 2017 / 6:43 PM / 7 months ago

Fitch Downgrades Och-Ziff Capital Management Group LLC to 'BB-'; Maintains Negative Watch

(The following statement was released by the rating agency) NEW YORK, February 23 (Fitch) Fitch Ratings has downgraded the Long-term Issuer Default Ratings (IDRs) of Och-Ziff Capital Management Group LLC and its related entities (collectively, OZM) to 'BB-' from 'BB+' following the company's release of fourth quarter 2016 (4Q16) earnings and 2017 guidance. The ratings remain on Rating Watch Negative (RWN). A full list of rating actions is at the end of this rating action commentary. KEY RATING DRIVERS IDR AND SENIOR UNSECURED DEBT The downgrades reflect OZM's significantly lower management fee earnings generation capacity and the resultant impacts on cash flow leverage and interest coverage ratios. Specifically, based on OZM's updated public guidance with respect to base salaries, bonus expense and non-compensation expenses for 2017, leverage is expected to be in excess of 5x and interest coverage is expected to remain near or below 3x, absent a material change in assets under management (AUM) and/or fee rates. The maintenance of the RWN continues to reflect the heightened probability of potential further negative rating action in the near term if AUM outflows accelerate or financial metrics materially weaken relative to current expectations. Fitch believes OZM's asset flows or fees could potentially be pressured by broader performance challenges facing the hedge fund industry, further investor reaction to OZM's $400 million Foreign Corrupt Practices Act (FCPA) settlement in September 2016, or some combination of the two dynamics. In its analysis of OZM, Fitch primarily relies on the company's non-GAAP reporting of economic income. Fitch takes a corporate approach, in which the focus is on debt service coverage and cash flow leverage rather than a balance sheet analysis. Fitch uses fee-related earnings before interest, taxes, depreciation and amortization (FEBITDA) as a proxy for cash flow in its review of OZM's debt service, which consists of management fees, less compensation expenses (including salary and bonuses equal to approximately 25% of management fees), excluding incentive income, less operating expenses, plus depreciation and amortization. In its most recent earnings release, OZM noted that in 2017, base salaries and benefits are expected to range between $100 million and $105 million, bonus expense is expected to range between $18 million and $20 million per quarter (subject to a true-up in the fourth quarter depending on the magnitude of incentive income generation), and non-compensation expenses, including interest expense, are expected to range between $140 million and $155 million. Based on these expense expectations, the Fitch-calculated FEBITDA margin is expected to be between 13.5% and 21.5% in 2017, generally in line with Fitch's 'bb' category quantitative earnings benchmark of 10% to 20%. Pro forma margins are down from reported margins of 21.8% in 2016 and OZM's longer-term historical range of 35%-45%. OZM's pro forma debt/FEBITDA, taking into account the 2017 expense guidance and the announced 1Q17 repayment of the revolver, is expected to range from 6.0x to 9.6x, consistent with Fitch's 'b' category quantitative leverage benchmark of greater than 5x. Pro forma leverage is up from 5.2x in 2016 and OZM's longer-term historical range of 1.5x to 2.5x. OZM's pro forma FEBITDA/interest expense, taking into account the 2017 expense guidance and the announced 1Q17 repayment of the revolver, is expected to range from 2.4x to 3.9x, which straddles Fitch's 'bb' and 'b' category quantitative coverage benchmarks of 3x-6x and less than 3x, respectively. Pro forma FEBITDA/interest expense is down from 4.6x at year-end 2016 and OZM's longer-term historical range of 9x to 30x. Ratings remain supported by the company's long-term performance track record, particularly in its core multi-strategy hedge fund business; adequate leverage, interest coverage and core profitability relative to ratings; and a seasoned management team. Fitch also continues to view the $400 million partner capital contribution in the form of preferred securities and the expected paydown of the revolving credit facility as important mitigants. Per Fitch's 'Criteria for Rating Non-Financial Corporates', dated Sept. 27, 2016, the partner capital contribution is treated as a shareholder loan. This reflects the strong alignment of interests between the preferred unitholders and common shareholders given significant cross-ownership and the limited likelihood that preferred unitholders would exercise the available contractual rights and remedies to the detriment of common shareholders or the institution more broadly. As such, Fitch does not treat the preferred securities as debt obligations of OZM. Key rating constraints beyond those articulated in the context of the rating downgrade and RWN include the elevated level of market risk due to the meaningful amount of net asset value (NAV)-based management fees; key man risk associated with the firm's founder and CEO, Daniel Och; and less diversified, albeit improving AUM relative to higher-rated alternative investment manager peers. Fitch also notes that reduced investor appetite for hedge funds as an asset class, combined with challenged performance relative to benchmarks, has pressured fund flows and fees for the hedge fund industry as a whole. OZM is a publicly traded holding company, and its primary assets are ownership interests in the operating group entities (OZ Management LP, OZ Advisors LP and OZ Advisors II LP), which earn management and incentive fees and are indirectly held through two intermediate holding companies. OZM conducts substantially all of its business through the operating group entities. Och-Ziff Finance Co. LLC serves as the debt-issuing entity for OZM's unsecured debt issuance, and benefits from joint and several guarantees from the management and incentive fee-generating operating group entities. Fitch's analysis of the unsecured debt relies on the joint and several guarantees provided by the operating group entities. The IDRs assigned to OZ Management LP, OZ Advisors LP, and OZ Advisors II LP are equalized with the ratings assigned to OZM, reflecting the joint and several guarantees among the entities. The senior unsecured debt is equalized with OZM's IDR reflecting the expectation of average recovery prospects for the instrument. RATING SENSITIVITIES IDR AND SENIOR UNSECURED DEBT Ratings could be downgraded if the residual effects of the settlement and/or investment underperformance result in material AUM outflows over the next three to six months. More specifically, outflows, fee pressure and/or the inability to meaningfully reduce expenses which translate into sustained leverage above 5x, interest coverage below 3x or materially reduced liquidity resources could contribute to negative rating action. Ratings may also be downgraded if fundraising capability is materially impaired or Fitch believes the franchise has experienced permanent reputational damage. OZM's ratings also continue to remain sensitive to a key man event with respect to Daniel Och. Fitch could remove the ratings from RWN and assign a Negative Outlook if the financial impacts, AUM outflows, fundraising capabilities, and/or franchise damage are deemed to be manageable in the context of OZM's financial profile. A stabilization of OZM's investment performance would also contribute to a removal from RWN and assignment of a Negative Outlook. Thereafter, a revision of the Outlook to Stable would be conditioned upon maintenance of investment performance and fee generation along with a stabilizing expense base. Positive ratings momentum is viewed as unlikely over the outlook horizon, but thereafter, could be driven by sustained leverage and interest coverage levels on a sustained basis to below 5x and above 3x, respectively. The senior unsecured debt rating is equalized with OZM's IDR and, therefore, would be expected to move in tandem with any changes to OZM's IDR. Were OZM to incur material secured debt, this could result in the unsecured debt being rated below OZM's IDR. Ratings are also sensitive to a change in the ownership of the preferred securities or a material reduction in common stock ownership by the preferred unitholders, either of which would eliminate the current alignment of interests between the investor classes. Under such a scenario, Fitch would treat the full notional amount of the preferred securities as debt, reflecting the cumulative nature of the instrument's dividends and change of control provisions, with interest rate step-ups and mandatory redemption terms. Such treatment, which would be consistent with Fitch's 'Treatment and Notching of Hybrids in Non-Financial Corporate and REIT Credit Analysis' dated February 2016, would likely have a material adverse impact on OZM's leverage and ratings. Fitch has downgraded the following ratings Och-Ziff Capital Management Group LLC OZ Management LP OZ Advisors LP OZ Advisors II LP --Long-Term IDRs to 'BB-' from 'BB+'. Och-Ziff Finance Co. LLC --Long-Term IDR to 'BB-' from 'BB+'; --$400 million senior unsecured debt to 'BB-' from 'BB+'. The ratings remain on Negative Watch. Contact: Primary Analyst Nathan Flanders Managing Director +1-212-908-0827 Fitch Ratings, Inc. 33 Whitehall Street New York, NY 10004 Secondary Analyst Meghan Neenan, CFA Senior Director +1-212-908-9121 Committee Chairperson Joo-Yung Lee Managing Director +1-212-908-0560 Media Relations: Hannah James, New York, Tel: + 1 646 582 4947, Email: hannah.james@fitchratings.com. 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