Howard Marks on Capital Allocation

© 2026 Oaktree Capital Management, L.P. All Rights Reserved Follow us: declining and/or ultra-low rates, as I wrote in Sea Change, the private equity industry enjoyed a great tailwind for much of its existence. This was particularly true of the period 2009-21, thirteen years in which the fed funds rate was zero most of the time and averaged about half a percent. Bottom line: private equity was born and existed through 2021 in an interest rate climate that was supportive of it in the extreme. Unsurprisingly, things went great. Investors concluded that private equity was a panacea; LP capital flowed in; and GPs were able to lever it up with freely available, low-cost debt capital, especially from direct lending after its arrival on the scene. The economic climate was supportive, featuring the longest recovery in U.S. history. A 10-year bull market made it easy for PE firms to sell their portfolio companies, as did the eagerness of new PE funds to deploy capital by buying companies from old PE funds. Returns lived up to expectations, as did distributions to LPs, and this enabled PE funds to continue attracting LP capital, perpetuating the “virtuous circle.” But early in 2022, the central banks decided to fight inflation by raising rates, and the fed funds rate (for example) went from zero to 5¼-5½%.

© 2023 Oaktree Capital Management, L.P. All Rights Reserved Follow us: changes I mentioned in that memo: the advent of high yield bonds in 1977-78, which brought about the trend toward bearing risk for profit and the emergence of levered investment strategies. It’s very notable that almost the entire history of levered investment strategies has been written during a period of declining and/or ultra-low interest rates. For example, I would venture that nearly 100% of capital for private equity investing has been put to work since interest rates began their downward move in 1980. Should it come as a surprise that levered investing thrived in such salutary conditions? • At the same time, declining interest rates rendered lending – or buying debt instruments – less rewarding. Not only were prospective returns on debt low throughout the period, but investors who were eager to get away from the ultra-low yields on safer securities like Treasurys and investment grade corporates competed spiritedly to deploy capital in higher-risk markets, and this caused many to accept lower returns and reduced lender protections. • Finally, conditions in those halcyon days created tough times for bargain hunters. Where do the greatest bargains come from? The answer: the desperation of panicked holders. When times are untroubled, asset owners are complacent, and buyers are eager, no one has any urgency to exit, making it very hard to score significant bargains.

© 2022 Oaktree Capital Management, L.P. All Rights Reserved Follow us: • Similarly, although most of us believe the free market is the best allocator of economic resources, we haven’t had a free market in money for well over a decade. The Fed might prefer to reduce its role in capital allocation by being less active in controlling rates and holding mortgage bonds. • There must be risks associated with the Fed keeping interest rates stimulative on a long-term basis. Arguably, we’ve seen most recently that doing so can bring on inflation, though the inflation of the last two years can be attributed largely to one-off events related to the pandemic. • The Fed would probably like to see normal interest rates high enough to provide it with room to cut if it needs to stimulate the economy in the future. • People who came into the business world after 2008 – or veteran investors with short memories – might think of today’s interest rates as elevated. But they’re not in the longer sweep of history, meaning there’s no obvious reason why they should be lower. These are the reasons why I believe that the base interest rate over the next several years is more likely to average 2-4% (i.e., not far from where it is now) than 0-2%. Of course, there are counterarguments. But, for me, the bottom line is that highly stimulative rates are likely not in the cards for the next several years, barring a serious recession from which we need rescuing (and that would have ramifications of its own).

Returns presented are either time-weighted rates of return and reflect both realized and unrealized gains and losses and the reinvestment of interest and other earnings or internal rates of return that are based on the annualized implied discount rate calculated from a series of investment cash flows. In addition, returns include the effects of recycling of invested and realized capital. The use of other return calculation methodologies including different assumptions or methods may result in different and possibly lower © 2021 OAKTREE CAPITAL MANAGEMENT, L.P.RESERVED

© 2020 Oaktree Capital Management, L.P. All Rights Reserved Follow us: early and dramatically, and Powell’s assurances that “we will not run out of ammunition” had a very positive effect. • The Fed said it would continue buying securities “for as long as it takes,” and since its actions suggested it was unconcerned about the ballooning deficits and debt, there was no apparent reason why its ability to keep buying had to have a limit. • When the Fed buys securities, it puts money into the hands of the sellers, and that money has to be reinvested. The reinvestment process, in turn, drives up the prices of assets while driving down interest rates and prospective returns. • There’s been a related expectation that the Fed’s buying might be less than discriminating. That is, there’s no reason to believe the Fed insists on good value, high prospective returns, strong creditworthiness to protect it from possible defaults, or adequate risk premiums. Rather, its goal seems to be to keep the markets liquid and capital flowing freely to companies that need it. This orientation suggests it has no aversion to prices that overstate financial reality. • Everyone is convinced that interest rates will be lower for longer. (On June 10, the Fed strongly indicated that there will be no rate increases through 2021 and possibly 2022.)

© 2018 Oaktree Capital Management, L.P. All Rights Reserved Follow us: In 2005-06, Oaktree adopted a highly defensive posture. We sold lots of assets; liquidated larger distressed debt funds and replaced them with smaller ones; avoided the high yield bonds of the most highly levered LBOs; and generally raised our standards for the investments we would make. Importantly, whereas the size of our distressed debt funds historically had ranged up to $2 billion or so, in early 2007 we announced the formation of a fund to be held in reserve until a special buying opportunity materialized. Its committed capital eventually reached nearly $11 billion. What caused us to turn so negative on the environment? The economy was doing quite well. Stocks weren’t particularly overpriced. And I can assure you we had no idea that sub-prime mortgages and sub-prime mortgage backed securities would go bad in huge numbers, bringing on the Global Financial Crisis. Rather, the reason was simple: with the Fed having cut interest rates in order to prevent problems, investors were too eager to deploy capital in risky but hopefully higher-returning assets. Thus almost every day we saw deals being done that we felt wouldn’t be doable in a market marked by appropriate levels of caution, discipline, skepticism and risk aversion. As Warren Buffett says, “the less prudence with which others conduct their affairs, the greater the prudence with which we should conduct our own affairs.

A market is nothing more than the people in it and the decisions they make, and the behavior of those people shapes the market. When people invest more in certain stocks than others, the prices of those stocks rise in relative terms. And when everyone decides to refrain from performing the functions of analysis, price discovery and capital allocation, the appropriateness of market prices can go out the window (as a result of passive investing, just as it does in a mindless boom or bust). The bottom line is that the wisdom of investing passively depends, ironically, on some people investing actively. When active investing is dismissed totally and all active efforts cease, passive investing will become imprudent and opportunities for superior returns from active investing will reemerge. At least that’s the way I see it. Quantitative Investing My next topic – which, as I said, I’m just learning about (and thus I write with some trepidation) – goes by names such as quantitative, algorithmic and systematic investing. In this memo I’ll use the first of those. As I understand it, quantitative investing consists of establishing a set of rules (perhaps with help from a computer) and having a computer carry them out. There are at least two principal forms of quantitative investing. The first might be called “systematic factor investing.

Investing consists almost entirely of making preparations for the future, and I just stated that the future is largely unknowable. Does this mean that there’s nothing we managers can do for our clients? No, quite the contrary. Investors who understand reality can restrict their efforts to areas in which they can make a difference and avoid wasting their time (or – even worse – taking unjustified risks) where they can’t. In fact, there’s a long list of things we can do for our clients despite our lack of prescience:  We can highlight potentially fruitful asset classes, strategies and approaches. Clients generally have no choice but to know a little bit about a great many things. But because specialist managers are supposed to know a lot about a few things, they should be able to identify superior opportunities and the best way to access them.  We can help inform the capital allocation decision by describing the attractiveness of our asset classes. We should know more than others about our markets’ fundamental strengths and weaknesses, technical conditions and price attractiveness. This doesn’t mean just speaking up when our markets are cheap; it also means admitting when they aren’t. It can’t always be “the greatest time” for any asset class.  We can strive to know more than others about companies, industries and securities. A knowledge advantage is a clear prerequisite for consistently superior investment © OAKTREE CAPITAL MANAGEMENT, L.P. ALL RIGHTS RESERVED.

© Oaktree Capital Management, L.P. All Rights Reserved. o a strong desire for economic growth and industrialization in order to move the population to the cities and upward in economic terms, o the need to respond to the global financial crisis of 2008 and the non-performing loans it produced, o an expectation that manufacturing would expand without limit as China supplied goods to nations around the world as well as its own growing consumer class, and o resulting certainty that China couldn’t miss. The upshot of all of the above was massive provision of capital in order to advance China’s economic development and urbanization. State-owned enterprises were created and expanded, and infrastructure building was accelerated. Residential construction, in particular, took place at an elevated rate. This may have been yet another instance where too much money led to bad capital allocation decisions. China’s modern era had seen only growth, not cycles of boom and bust. Even when the central government wanted to rein in the rate of building, local governments – which derive a lot of their revenue from sales of land for development – were not similarly motivated. Chinese individuals faced very limited options for investing their capital: bank interest was below the rate of inflation and thus negative in real terms, and foreign investment was prohibited.

© Oaktree Capital Management, L.P. All Rights Reserved advances and no one – except bargain hunters and investors in distress – relishes pullbacks. But I wonder if that stance makes sense. How can we have gains but not losses? How can a free-market economy allocate capital effectively if capital creation is abetted and capital destruction is prevented? The fact is, excesses like we’ve just seen have to be corrected – painfully – and if they aren’t, they’ll just grow bigger and bigger as the cycles wear on. “Moral hazard” will arise, convincing people that risk takers will always be bailed out, something that’s bound to encourage greater risk taking. The Fed’s actions in the current situation have been dramatic:  an unexpectedly large half-point cut in the discount rate in September,  strong steps to inject liquidity and encourage borrowing by banks, and  an unusual ¾-point rate cut on January 21, followed by another ½ point a week later. In two decades as Fed Chairman, Alan Greenspan was required to deal with the emerging market crisis and meltdown of Long Term Capital Management in 1998; the possibility of a Y2K glitch; the tech stock and broader bear market in 2000-02; the ramifications of the 9/11 attack; and concern over the possibility of deflation. And yet he never cut rates by ¾ point in one step or by 1-¼ points in just eight days. Thus Bernanke’s actions seem extreme. Is the Fed attempting to prevent a normal recession?

from addressing localized fundamental problems. Instead, the problem is hydra-headed, affecting a large number of areas due to contagion. Larry Summers put it this way: You have three vicious cycles going on simultaneously. A liquidity vicious cycle -- in which asset prices fall, people sell and therefore prices fall more; a Keynesian vicious cycle -- where people's incomes go down, so they spend less, so other people's income falls and they spend less; and a credit accelerator, where economic losses cause financial problems that cause more real economy problems. There is no schematic diagram for the workings of the economy and the markets, as in “if we do A, the result will be B.” That’s particularly true for the current crisis, since some of the financial techniques that gave rise to it are new; others haven’t been used to the same extent; and they’ve never been combined as they were in the last few years. In particular, the workings of economies and markets depend heavily on psychology, which can’t be treated as if it’s hard-wired. Thus the people trying to address this bust can only work from hypotheses and try possibilities. The Fed and the administration are determined to solve the problem, but we’re unlikely to have the unwind we need without pain. As I wrote in “Whodunit,” in order for efficient capital allocation decisions to be made, an economic system that aims to create capital has to witness capital destruction from time to time.

© Oaktree Capital Management, L.P. All Rights Reserved income investing is, and how substantial is the “reinvestment risk.” And beyond bonds, it’s even more up for grabs. What rate of return is implicit in equity investing? Certainly we should look to more than just returns over the last ten or twenty years for the answer. The rate of growth in corporate profits provides a clue, but in the short run, changes in p/e ratios tend to swamp changes in profits. In 1999, investors asked, “What’s been the return on common stocks?” and were seduced by the 11% answer propounded by authorities like Prof. Jeremy Siegel in his book, “Stocks for the Long Run.” What they should have asked, however, is, “What’s been the return on common stocks bought when the Standard & Poor’s 500 was priced at 29 times earnings?” (which it was at the time). In other words, people made the mistake of believing that common stocks have a single rate of return you can depend on, regardless of entry point. They forgot the great extent to which the return on an asset is dependent on the price you pay for it. In the March/April 1997 issue of the Financial Analysts Journal, Peter Bernstein set forth a helpful way to consider returns from equities – one I’d thought about but had never seen in use. He calculated returns on the S&P 500 for periods spanning widely separated dates between which the p/e ratio didn’t change. He called the result “valuation-adjusted long-run equity returns.

Because so few stocks are bought today for asset values, we essentially can disregard them. The vast majority of stocks are bought for the stream of earnings the companies produce. But how do those earnings affect investors – get through to investors – if not in the form of dividends? That's the question that drove me in the 1960s. It almost verges on metaphysical. If a company has great earnings but those earnings aren't ever paid out in dividends, are they still of value to investors? If it makes a bunch of money but just hoards it, or reinvests it in new products and facilities that generate future earnings that also are not paid out, in what way are its profits of value to investors? That's kind of like the old question, "if a tree falls in the forest but there's no one around to hear it, does it still make noise?" There are two possible answers:  Eventually, earnings must be paid out. Common sense tells us that, sooner or later, every company will run out of good reinvestment opportunities, and the cash will then go to dividends, or to stock buy-backs, which have the same effect but better tax treatment. (Of course, the record suggests that when they run out of good reinvestment opportunities, companies often prefer bad reinvestment opportunities to giving the money to the shareholders.)