Howard Marks on Debt Discipline

© 2026 Oaktree Capital Management, L.P All Rights Reserved Follow us: Memo to: Oaktree Clients From: Howard Marks Re: What’s Going on in Private Credit? The general field called “credit” has seen massive innovation over the course of my career. Its popularity has increased steadily, and its scale and role in the world of finance have multiplied. The other day, an Oaktree colleague asked me about the developments that brought the credit sector to where it is today. I came up with the following list: Time of Inception 1970s Acceptance of non-investment grade debt 1980s Popularization of leveraged buyouts and increased corporate leverage 1990s Broadly syndicated loans and tranched securitizations 2000s The rising trend toward “alternative” investments Sub-prime mortgage lending and mortgage-backed securities 2010s Expansion of direct lending 2020s Marketing of direct lending vehicles to individual and retirement investors The investment world I first encountered in the summer of 1968, consisting exclusively of stocks and high-grade bonds, seems quaint and provincial in retrospect given the developments listed above. These advances have transformed the investment management business, and Oaktree and its clients have been major beneficiaries. All the changes listed above involved – or were facilitated by – the thing now broadly called “credit” – essentially non-government debt. I’ll lay out a brief chronology to set the scene.

© 2026 Oaktree Capital Management, L.P. All Rights Reserved Follow us: amounts, growing to today’s market of roughly $1.5 trillion in the U.S. The significant increase in the ability to issue this type of financing helped fuel the growth of private equity. After the tech bubble of the late 1990s imploded in 2000, leading to the first three-year decline in the S&P stock index since the Great Depression, investors became uninterested in the stock market and stayed that way for a decade. And when central banks reduced interest rates to fight the resulting economic and market malaise, investors sought returns above those available on bonds. With stocks and bonds out of favor, investors looked for a new solution. They turned to hedge funds and private equity, which had held up relatively well, and the label “alternative investments” was born. Hedge funds couldn’t find enough bargain-priced opportunities to accommodate large amounts of institutional capital, so many investors gravitated toward private equity as the solution du jour. The first $10 billion private equity funds were organized. Around the same time, corporate debt began to be securitized in “structured credit” vehicles such as collateralized loan obligations, or CLOs. The banks that packaged these vehicles, with internal leverage from “tranching,” found eager buyers for both the high-yielding junior classes and the overcollateralized senior classes.

© 2026 Oaktree Capital Management, L.P. All Rights Reserved Follow us: In recent years, sponsors have increasingly turned to direct lending as an alternative to broadly syndicated loans, as the former allowed them to get the capital they needed from a few big lenders, freeing them from protracted road shows, widely distributed financial disclosure, and having to deal with a large number of counterparties if trouble necessitated renegotiation. Direct lenders have also shown a willingness to support higher debt levels, enabling sponsors to achieve leverage beyond what the syndicated loan market might accommodate. They’ve also been willing to lend more to companies that are not yet profitable in the form of “ARR loans” based on annual recurring revenue. The attractiveness to sponsors of loans versus bonds and private versus public brought the representation of software debt in the U.S. sub-investment grade credit markets to roughly the following proportions: High yield bonds 4-5% Broadly syndicated loans 10-15% Direct lending 20-30% In addition, thanks to the same factors, the percentage of software debt that is to companies that were the subject of leveraged buyouts (meaning they’re more highly levered) is higher in the broadly syndicated loan market than in the high yield bond market, and higher still in the direct lending market.

As a result of all the above, a significant portion of direct loans were made to software companies, which were often acquired at high EBITDA multiples of ~20x and with high leverage ratios. Now, suddenly, software company debt is in the news. Over the last year or two, artificial intelligence has significantly reduced the need for humans to write code (that is, program computers or write software), largely relegating coders to instructing AI models what to do. The market for software company stocks and debt didn’t react much in 2024-25. Then, in November 2025, Anthropic released a powerful new model for coding, followed in late January by the release of 11 “plug-ins” to automate tasks in a number of fields. It seems a cognitive tipping point was reached in the first days of February. Investors finally took notice of the negatives that had accumulated, and the private credit market has faced scrutiny and volatility ever since: • Worry about software debt made investors in semi-liquid public vehicles put in for redemptions. • Limits on redemptions caused investors to question the safety of their investments. • The process through which some investors got out at the stated net asset value might have caused those remaining to question whether the NAVs people exited at were overstated and if so what the impact might be on them. • When funds limited redemptions, investors might reasonably have concluded that they should put more shares in for withdrawal next time.

Now the analysis errs in the opposite direction, with excessive pessimism and skepticism replacing eagerness and gullibility, and with sheer terror replacing the blind faith that enabled investment when everything was going well. The implications of AI for the software industry, limitations on liquidity in private assets, and uncertainty regarding the accuracy of direct lending funds’ pricing have been there for years. But, simply put, people may not have asked enough questions or paid enough attention in the good times . . . as usual. This has led to the current discomfort of investors in direct lending vehicles. Individual investors in a new phenomenon like direct lending are unlikely to fully grasp its potential complications, especially if it has never been seen in action during tough times. The inclusion of leverage in the vehicles may have been touted as profit-enhancing, and now investors are seeing it at work in the opposite direction. And the investment vehicles’ limitations on liquidity – which may have been glossed over with a representation that “most of the time, you’ll probably be okay” – has come into play with surprising effect. True believers make the most money in manias, and skeptics lose the least when they crash. But the key to the investment success we aim for lies in always maintaining a healthy balance between belief and doubt.

© 2026 Oaktree Capital Management, L.P. All Rights Reserved Follow us: to be learned from 1929, along the lines of my favorite books about market excesses: A Short History of Financial Euphoria by John Kenneth Galbraith (1994) and Devil Take the Hindmost: A History of Financial Speculation by Edward Chancellor (2000). My take from 1929 was that three things in particular were primarily responsible for the bubble that ended in the Great Crash: • the sale of stock to the public without regard for suitability, • the provision of heavy leverage to the buyers, and • the mismatch between the illiquidity of the assets bought and the short-term nature of the loans that financed the purchases. Individual investors were lured into the stock market following an ascent that had gone on for years; the major stock market averages had already risen by roughly 400% between 1921 and 1928. Brokerage firms, hungry for commissions and markups on larger transactions, provided margin loans for up to 90% of the purchase price. And those loans could be called – and the positions sold out – if a decline wiped out the investor’s 10% equity and additional cash couldn’t be posted. The story sounds familiar (and has been repeated several times since): • A lack of financial sophistication on the part of individual investors leaves them susceptible to promotions and too-good-to-be-true promises.

• Leverage is described as capable of magnifying the fruits of success, but the corresponding downside risk is often omitted from the sales pitch. • The perhaps-unmentioned terms of margin debt – and the difficulty of imagining the full depth of a potential market decline – expose investors to the risk of ruin. It’s not easy to lose everything in the stock market, but the combination of these three elements can do the trick in a bad-enough boom/bust cycle. The things described above took place in 1929 against the background of a near-total absence of laws governing the investment business, including requirements for honesty in prospectuses, and were compounded by the self-serving delusion, lack of principles, and downright venality of some Wall Street leaders. The result was a market and economic catastrophe that scarred several generations. Sorkin mostly limits himself to chronicling his characters’ behavior, leaving the drawing of conclusions and morals until the very end. But he finishes with a punch: The devastation wrought by the stock market’s decline – not just during the crash itself but for most of the ensuing decade – caused millions of Americans insufferable pain. It caused them to not just turn away from the market but to revile those who made their living buying and selling stocks. Yet the forces that drove the market to such stratospheric levels – optimism, ambition, and the belief that the future could be endlessly brighter – did not disappear forever.

However, a substantial part of the gains resulted – without as much recognition as might have been due – from the interest rate climate private equity grew up in. In December 2022, I wrote a memo called Sea Change. In it I talked about a bank loan I had outstanding in 1980 and the slip I got in the mail informing me that my interest rate had risen to 22¼%. Then, I said, I was able to borrow at 2¼% in 2020. I consider that 40-year, 2,000-basis point decline in interest rates the most impactful event in the financial world in the last half-century, but one that has received inadequate attention. Among other things, declining rates make assets more valuable (leading to the asset bubbles central bankers worry about) and reduce the cost of borrowing. Thus, when rates fall, people who bought assets using borrowed money get a double bonus. And that’s exactly what private equity does.to

The essential message of Sea Change was that the days of ultra- low and secularly declining interest rates were over, and the investment strategies that had benefitted most from them would do less well in the future. The Sea Change memo was the product of a trip Bruce Karsh and I made to clients in the fall of 2022, when travel first became possible post-pandemic. I’ll never forget the way Bruce summed up the situation: “In the last several years, a lot of private equity companies have been saddled with capital structures that didn’t anticipate a 400-basis point increase in interest rates.” The rate rise “threw sand in the gears” of private equity, and the picture today is very different from that described above: • Higher interest costs have made many portfolio companies less profitable. Deals that were very lucrative when the cost of leverage was low now make less economic sense. • Higher rates have meant higher interest bills and thus lower coverage ratios – the ratio of earnings to interest expense – making it more difficult to refinance debt taken on when rates were low. • Rising interest rates reduced the value to buyers of companies’ future cash flows, just as falling rates had increased it. • Thus, the prices at which portfolio companies can be sold is lower, and sales of portfolio companies have slowed.

Current Events Given the suggestion that fraud may have played a role in both the First Brands and Tricolor bankruptcies, and given that both companies had borrowed in the private credit market, people saw a connection. Is this the beginning of a problem? As I mentioned in my memo Gimme Credit in March, the thing people have asked me about most often over the last few years is private credit. The sector took root around 2011, when banks were limited in making loans following the Global Financial Crisis and money managers stepped in to fill the void, primarily lending to leverage-hungry private equity sponsors. Because lenders were few, those who would put out money were able to demand high interest rates and a high level of safety. These loans looked good to investors in the low-rate environment that prevailed. Thus, private credit was anointed as a magic investment solution, with perhaps $2 trillion flowing into the sector in the subsequent years. The arrival of new entrants and a great deal of incremental capital created more competition to lend and inevitably reduced some of the lenders’ advantages. When asked about private credit, I answered that the investment environment had been mostly benign over the years since 2011, meaning – to echo Warren Buffett – the tide had never gone out on private credit (i.e., it hadn’t been tested). Now, with two high-profile bankruptcies in short order, people thought they might be starting to see cracks.

• The average high yield bond’s credit rating (supposedly an indicator of quality) has risen substantially. Mainly because companies are less concerned about ratings these days, large numbers of investment grade triple-B-rated companies have opted to increase their use of leverage and allow their rating to slip to double-B, the upper tier of the high yield bond universe. The following table shows the change in the ratings profile of the high yield bond universe over the last 25 years: December 31, 1999 December 31, 2024 BB 32.7% 52.6% B 54.6 33.7 CCC and below 12.7 13.ICE

© 2025 Oaktree Capital Management, L.P. All Rights Reserved Follow us: consideration for people with responsibility for pension plans. It’s absolutely internal to them and their process. And, of course, pension funds are but one example of the type of investor who may consider volatility a risk. University endowments are another example. Typically, universities rely upon an annual “draw” from the endowment to fund a material portion of their operating expenses. Volatility in the value of the endowment can affect the amount of that draw and require unplanned changes to a university’s operations. We saw this very clearly when the Global Financial Crisis hit in 2008. Choice of Investment Approach The consultant did a good job of covering questions regarding strategies and tactics, and the board gave good answers. Here are a few of the areas they touched on: • All board members agreed that it’s impossible to foresee the future, and thus that the portfolio should be built to prepare for “all environments” rather than base performance expectations on the ability to time markets. Of course this is the right attitude, even though it’s impossible to (a) specify “all environments” or (b) build a portfolio that entails the risk inherent in investing but is capable of performing well in all environments. • A substantial majority of the members said they’re comfortable with using leverage at 15-20% of the plan’s assets. I think this is reasonable.

A well-funded plan that’s sponsored by a financially strong employer and invested conservatively should be able to withstand the uncertainties associated with this level of leverage. While most public plans may not use leverage, I think it makes sense for this one. However, (a) it’s still essential to deal with the risk of the lender pulling the leverage at a bad time in the investment and capital markets and (b) paying interest to borrow makes it even more important that the plan not hold a lot of assets whose only merit is a highly dependable low return (or, in this case, a return below its borrowing cost). • A slimmer majority backed putting 25% of the portfolio into illiquid assets “assuming all benefit payments and foreseen funding requirements can be met.” However, a few thought a higher promised return isn’t a good reason for surrendering flexibility. Clearly, some part of a well- funded plan’s assets can reasonably be illiquid, but getting that percentage right is no simple matter. • Slightly more members were in favor of focusing exclusively on expected returns net of fees, while a few thought minimization of fees should be a goal in itself. This is a tough area. No one wants to pay high fees and not get above average performance. But when you sign up for a fund with stiff fees, the performance is hoped for while the fees are a sure thing. All you have to do is figure out which high-fee funds are likely to deliver and which aren’t. Not an easy task.

My belief is that the risk in private credit isn’t systemic, since (a) private loan portfolios and their owners aren’t levered nearly as much as banks were in 2007-08 and (b) there isn’t the same level of interconnectedness, or “counterparty risk,” since the holders haven’t sold each other default protection and other forms of hedging, like banks did before the GFC. There are those who believe some holders of private credit have multiple layers of leverage, which could increase the risk in a downside scenario, but I have no way of knowing. The bottom line for me is that the return premium on private credit relative to public credit seems roughly fair given the merits. Extra return is a good thing, but the downside related to the lack of liquidity and resulting difficulty in actively managing holdings is a real consideration. All else equal, I would suggest employing a combination of the two. Credit Versus Equities I’ve written about equity valuations – primarily referencing the Standard & Poor’s 500 – as recently as this January in my memo On Bubble Watch.year,

Many companies justify their spending because they’re not just building a product, they’re creating something that will change the world: artificial general intelligence, or A.G.I. . . . The rub is that none of them quite know how to do it. But Anton Korinek, an economist at the University of Virginia, said the spending would all be justified if Silicon Valley reached its goal. He is optimistic it can be done. “It’s a bet on A.G.I. or bust,” Dr. Korinek said. (The New York Times, November 20 – emphasis added) The yet-to-be-determined nature of the industry under construction is best captured in remarks from Sam Altman, the CEO of OpenAI, that have been paraphrased as follows: “we’ll build this sort of generally intelligent system and then ask it to figure out a way to generate an investment return from it.” This should be a source of pause for people who heretofore fully comprehended the nature of the businesses they invested in. Clearly, the value of a technology that equals or surpasses the human brain should be pretty big, but isn’t it well beyond calculation? A Word About the Use of Debt To date, much of the investment in AI and the supporting infrastructure has consisted of equity capital derived from operating cash flow. But now, companies are committing amounts that require debt financing, and for some of those companies, the investments and leverage have to be described as aggressive. The AI data centre boom was never going to be financed with cash alone.

© 2025 Oaktree Capital Management, L.P. All Rights Reserved Follow us: Here are some important paragraphs from Azeem Azhar’s Exponential View of October 18: When does an AI boom tip into a bubble? [Investor and engineer] Paul Kedrosky points to the Minsky moment – the inflection point when credit expansion exhausts its good projects and starts chasing bad ones, funding marginal deals with vendor financing and questionable coverage ratios. For AI infrastructure, that shift may already be underway; the telltale signs include hyperscalers’ capex outpacing revenue momentum and lenders sweetening terms to keep the party alive. Paul makes a compelling case. We’ve entered speculative finance territory – arguably past the tentative stage – and recent deals will set dangerous precedents. As Paul warns, this financing will “create templates for future such transactions,” spurring rapid expansion in junk issuance and SPV proliferation among hyperscalers chasing dominance at any cost. . . . For AI infrastructure, the warning signs are flashing: vendor financing proliferates, coverage ratios thin, and hyperscalers leverage balance sheets to maintain capex velocity even as revenue momentum lags. We see both sides – genuine infrastructure expansion alongside financing gymnastics that recall the 2000 telecom bust. The boom may yet prove productive, but only if revenue catches up before credit tightens. When does healthy strain become systemic risk?

© 2025 Oaktree Capital Management, L.P. All Rights Reserved Follow us: Debt is neither a good thing nor a bad thing per se. Likewise, the use of leverage in the AI industry shouldn’t be applauded or feared. It all comes down to the proportion of debt in the capital structure; the quality of the assets or cash flows you’re lending against; the borrowers’ alternative sources of liquidity for repayment; and the adequacy of the safety margin obtained by lenders. We’ll see which lenders maintain discipline in today’s heady environment. It’s worth noting in this connection that Oaktree has made a few investments in data centers, and our parent, Brookfield, is raising a $10 billion fund for investment in AI infrastructure. Brookfield is putting up its own money and has equity commitments from sovereign wealth funds and Nvidia, to which it intends to apply “prudent” debt. Brookfield’s investments seem likely to go largely into geographies that are less saturated with data centers and for infrastructure to supply the vast amounts of electric power that data centers will require. Of course, we’re both doing these things on the basis of what we think are prudent decisions. I know I don’t know enough to opine on AI. But I do know something about debt, and it’s this: • It’s okay to supply debt financing for a venture where the outcome is uncertain. • It’s not okay where the outcome is purely a matter of conjecture.

© 2024 Oaktree Capital Management, L.P. All Rights Reserved Follow us: warming for over a year. In addition, and importantly, the announcement played havoc with investors who had engaged in “the carry trade.” For years, Japan’s infinitesimal – and often negative – interest rates have meant that people could borrow cheaply in Japan and invest the borrowed funds in any number of assets, there and elsewhere, that promised to return more, for a “positive carry” (aka “free money”). This led to the establishment of highly levered positions. It seems odd that a quarter-point increase in interest rates could require some of these positions to be unwound. But it did, leading to motivated selling in a variety of asset classes as those who had engaged in the practice moved to cut their leverage. Starting the next day, the U.S. announced mixed economic news. On August 1, we learned that the Manufacturing Purchasing Managers’ Index had dipped and initial jobless claims had risen. On the other hand, corporate profit margins continued to look good, and gains in productivity surprised to the upside. A day later, we learned that employment gains had moderated, with hiring rising less than had been expected. The unemployment rate stood at 4.3% at the end of July, up from a low of 3.4% in April 2023.

© 2024 Oaktree Capital Management, L.P. All Rights Reserved Follow us: Housel’s approach to thinking about debt – and especially his illustrations – reminded me of my December 2008 memo, Volatility + Leverage = Dynamite. (Unless otherwise indicated, this memo is the source of the quotations that follow; in all cases, emphasis is in the original.) In that memo, I used a series of simple graphics to show that the lower a company’s debt load is, the greater the decline in fortune it could survive. And I made the following observation about the root cause of the Global Financial Crisis, which was in full force at the time of the memo: . . . the amount of borrowed money – leverage – that it’s prudent to use is purely a function of the riskiness and volatility of the assets it’s used to purchase. The more stable the assets, the more leverage it’s safe to use. Riskier assets, less leverage. It’s that simple. One of the main reasons for the problem today at financial institutions is that they underestimated the risk inherent in assets such as home mortgages and, as a result, bought too much mortgage-backed paper with too much borrowed money. Portfolios, Leverage, and Volatility The reason for taking on debt – i.e., using what investors call “leverage” – is simple: to increase so-called capital efficiency. Debt capital is usually cheap relative to the expected returns that motivate equity investments and thus relative to the imputed cost of equity capital.

Thus, it’s efficient to use it in lieu of equity. In casinos, I’ve heard the pit boss say, “The more you bet, the more you win when you win.” Likewise, for a given amount of equity capital, (a) the more debt capital you use, the more assets you can own and (b) the more assets you own, the greater your profits will be . . . when things go well. But few people talk about the downside. The pit boss never says, “. . . and the more you lose when you lose.” Likewise, when your assets decline in value, the more leverage you’ve employed, the more equity loss you’ll suffer. The magnification of gains and losses stemming from leverage is typically symmetrical: a given amount of leverage amplifies gains and losses similarly. But levered portfolios face a downside risk to which there isn’t a corresponding upside: the risk of ruin. The most important adage regarding leverage reminds us to “never forget the six-foot-tall person who drowned crossing the stream that was five feet deep on average.” To survive, you have to get through the low points, and the more leverage you carry (everything else being equal), the less likely you are to do so. . . . it’s important to recognize the role of volatility.

Even if losses aren’t permanent, a downward fluctuation can bring risk of ruin if a portfolio is highly leveraged and (a) the lenders can cut off credit, (b) investors can be frightened into withdrawing their equity, or (c) the violation of regulatory or contractual standards can trigger forced selling. Obviously, the greatest leverage-related losses occur when the potential for downward fluctuations has been underestimated for a meaningful period of time and thus the use of leverage has become excessive. Generally speaking, “normal levels of volatility” – those seen on a regular basis and documented through historical statistics – are used in investors’ calculations and reflected in the amounts of leverage they employ. It’s the isolated “tail events” that saddle levered investors with the greatest losses: © 2024 OAKTREE CAPITAL MANAGEMENT, L.P.RESERVED

© 2024 Oaktree Capital Management, L.P. All Rights Reserved Follow us: The problem is that extreme volatility and loss surface only infrequently. And as time passes without that happening, it appears more and more likely that it’ll never happen – that assumptions regarding risk were too conservative. Thus, it becomes tempting to relax rules and increase leverage. And often this is done just before the risk finally rears its head. As Nassim Nicholas Taleb wrote in Fooled by Randomness: Reality is far more vicious than Russian roulette. First, it delivers the fatal bullet rather infrequently, like a revolver that would have hundreds, even thousands of chambers instead of six. After a few dozen tries, one forgets about the existence of a bullet, under a numbing false sense of security . . . Second, unlike a well-defined precise game like Russian roulette, where the risks are visible to anyone capable of multiplying and dividing by six, one does not observe the barrel of reality. . . . One is thus capable of unwittingly playing Russian roulette – and calling it by some alternative “low risk” name. . . . In all aspects of our lives, we base our decisions on what we think probably will happen. And, in turn, we base that to a great extent on what usually happened in the past. We expect results to be close to the norm most of the time, but we know it’s not unusual to see outcomes that are better or worse.

Although we should bear in mind that, once in a while, a result will be outside the usual range, we tend to forget about the potential for outliers. And importantly, as illustrated by recent events, we rarely consider outcomes that have happened only once a century . . . or never. Cycles in the Use of Leverage In my second book, Mastering the Market Cycle: Getting the Odds on Your Side, one of the longest chapters, and probably the most important, is one I hadn’t planned when I first sat down to write: “The Cycle in Attitudes Toward Risk.” Investor psychology has a dominant influence on the market in the short run, and the attitudes that motivate investment decisions are often cyclical in nature, driving markets to irrational extremes and then correcting in the opposite direction . . . to the opposite extreme. Attitudes that govern the use of debt capital are examples of this cyclical process. When things have been going well for a while – asset prices have been rising, investment returns have been positive, and the use of leverage has paid off in the form of higher returns – investors view leverage as benign. As a result: • the favorable aspects of leverage become well-recognized, • the negative potential is overlooked, • investors become interested in employing more, • lenders become willing to provide more, and • regulations and mores governing the use of leverage tend to become more permissive. But when events turn negative, this process goes into reverse.

Leverage is penalized, not rewarded. Thus, its use declines. And importantly, lenders provide less and try to demand repayment of outstanding leverage if they can, leading to negative consequences for borrowers. In this way, as we so frequently see, psychology often strays from the “happy medium” and moves toward extreme highs that presage painful losses when extreme lows are reached. The source of losses from excessive use of leverage might be best understood through an adaptation of my favorite new quote, from Edward Chancellor’s book The Price of Time, which I cited in this past © 2024 OAKTREE CAPITAL MANAGEMENT, L.P.RESERVED

© 2024 Oaktree Capital Management, L.P. All Rights Reserved Follow us: January’s memo Easy Money: The Manchester Banker John Mills commented perceptively [in 1865] that “as a rule, panics do not destroy capital; they merely reveal the extent to which it has previously been destroyed by [the taking on of excessive leverage in good times].” Using Debt Prudently As with so many aspects of investing, determining the proper amount of leverage has to be a function of optimizing, not maximizing. Given that leverage magnifies gains when there are gains and that investors only invest when they expect there to be gains, it can be tempting to think the right amount of leverage is “all you can get.” But if you bear in mind (a) leverage’s potential to magnify losses when there are losses and (b) the risk of ruin under extreme negative circumstances, investors should usually use less than the maximum available. Successful investments, perhaps enhanced by the moderate use of leverage, should usually provide a good-enough return – something few people think about in good times. Here’s how I summed it up in Volatility + Leverage = Dynamite: Clearly, it’s difficult to always use the right amount of leverage, because it’s difficult to be sure you’re allowing sufficiently for risk. Leverage should only be used on the basis of demonstrably cautious assumptions.

And it should be noted that if you’re doing something novel, unproven, risky, volatile, or potentially life-threatening, you shouldn’t seek to maximize returns. Instead, err on the side of caution. The key to survival lies in what Warren Buffett constantly harps on: margin of safety. Using 100% of the leverage one’s assets might justify is often incompatible with assuring survival when adverse outcomes materialize. . . . The riskier the underlying assets, the less leverage should be used to buy them. Conservative assumptions on this subject will keep you from maximizing gains but possibly save your financial life in bad times. The right way to think about debt may be best captured by one of the oldest maxims: “There are old investors, and there are bold investors, but there aren’t many old bold investors.” Using a moderate amount of borrowed capital balances the desire for enhanced gains against the awareness of the potential negative consequences. It’s only in this way that one can hope to attain the longevity of Morgan Housel’s 500-year-old success stories. May 8, 2024 © 2024 OAKTREE CAPITAL MANAGEMENT, L.P.RESERVED

© 2024 Oaktree Capital Management, L.P. All Rights Reserved Follow us: want to aim for. The ratio of return to risk is similar at all points on the continuum – less of both toward the left, and more of both toward the right. Said another way, there’s no free lunch. • Also, looking at each position on the risk continuum, the symmetricalness of the vertical distribution of possible returns around the expected return is similar from one position to the next. That means the ratio of upside potential to downside risk at one position on the continuum isn’t markedly better than it is at other positions – again no free lunch. • Finally, if you want to move further out on the risk continuum, you can do so by either (a) investing in riskier assets or (b) applying leverage to the same assets (magnifying both the expected return and risk). Again, in a fully efficient market, neither tactic is preferable to the other. The above three statements capture some of the important implications of supposed market efficiency. Looked at this way, the only thing that matters is getting to the right risk position for you; under an assumption of market efficiency, there’s nothing to be gained in terms of return at a given level of risk. All ways of getting to a certain risk level will produce the same expected return.

vi. Low interest rates encourage greater use of leverage, increasing fragility Borrowed money – leverage – is the mother’s milk of rapid expansion and speculation. In my memo It’s All Good (July 2007), I compared leverage to ketchup: “I was a picky eater when I was a kid, but I loved ketchup, and my pickiness could be overcome with ketchup.” Ketchup got me to eat food I otherwise would have considered inedible. In much the same way, leverage can make otherwise unattractive investments investible. Let’s say you’re offered a low-rated loan yielding 6%. “No way,” you say, “I’d never buy a security that risky at such a low yield.” But what if you’re told you can borrow the money to buy it at 4%? “Oh, that’s a different story. I’ll take all I can get.” But it must be noted that cheap leverage doesn’t make investments better; it merely amplifies the results. In times of low interest rates, absolute prospective returns are low and leverage is cheap. Why not use a lot of leverage to increase expected returns? In the late 2010s, money flowed to both private equity, given its emphasis on leveraged returns from company ownership, and private credit, which primarily provides debt capital to private equity deals. These trends complemented each other and led to a significant upswing in levered investing.

But in the last decade, some companies acquired by private equity funds were saddled with capital structures that failed to anticipate the increase in interest rates of 400-500 basis- points. Having to pay interest at higher rates has reduced these companies’ cash flows and interest coverage ratios. Thus, companies that took on as much debt as possible – based on their former levels of earnings and the prevailing low interest rates – may now be unable to service their debt or roll it over in a higher-rate environment. Finally, all else being equal, the more leverage that’s piled on a company, the lower the probability it’ll be able to survive a rough patch. This is one of the foremost reasons for the adage “never forget the six-foot-tall man who drowned crossing the stream that was five feet deep on average.” Heavy leverage can render companies fragile and make it hard for them to get through the proverbial low spots in the stream. Take, for example, Signa, a large privately owned © 2024 OAKTREE CAPITAL MANAGEMENT, L.P.RESERVED

© 2024 Oaktree Capital Management, L.P. All Rights Reserved Follow us: politics. A central bank’s decision to set rates that subsidize some and penalize others clearly has consequences. x. Low rates induce optimistic behavior that lays the groundwork for the next crisis Elevated risk taking, underestimating future financing costs, and increased use of leverage often lie behind investments that fail when tested in subsequent periods of stringency, bringing on the next crisis and perhaps the need for the next rescue. In this way, excesses in one direction typically precede excesses in the other direction. In October 1889, the Governor of the Bank of England, William Lidderdale, delivered a stern warning to the City: The present tendency of finance . . . is distinctly in the direction of danger, too much capital is being forced into industrial developments, financiers are taking larger & larger risks in securities which require prosperity & easy money to carry without becoming a burden, & an increased number of investments have been driven up in price by the combined efforts of a long period of cheap money & depression in trade . . . we have most of the elements of a Crisis. (TPOT) The Never-Ending Story One of the quotes I return to most frequently is Mark Twain’s purported observation that “history doesn’t repeat itself, but it often rhymes.

This rate, which is neither stimulative nor restrictive, has most recently been estimated to be 2.5%. • The Fed might want to get out of the business of controlling rates and let supply and demand set the price of money, which hasn’t been the case for a quarter century. • Having had a taste of inflation for the first time in decades, the Fed might keep the fed funds rate high enough to avoid encouraging another bout. To control inflation, one would think the rate would need to be kept positive in real terms. If inflation will be, say, 2.5%, the fed funds rate would by definition have to be above that. • Perhaps most importantly, one of the Fed’s essential jobs is to enact stimulative monetary policy if the economy falls into recession, largely by cutting rates. It can’t do that effectively if the rate is already zero or 1%. To this list, I would add a few more reasons for not returning to ultra-low interest rates, including the tendency of easy money to (a) induce risk taking and “malinvestment”; (b) encourage increased use of leverage; (c) produce asset bubbles; and (d) create economic winners and losers. Finally, cutting rates to stimulative territory as soon as inflation hits 2% could cause it to reaccelerate. Instead, the plan should be to get inflation to 2% and then keep rates at a level that is neither stimulative nor restrictive.

After listing the above bulleted arguments against renewed low rates, I went on in Sea Change to say the following (despite my strong aversion to predictions): 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 . . . Most people – other than lenders and savers – want low interest rates: people (and businesses) with floating-rate mortgages and other debt, consumers in general, homebuilders, car and boat dealers, private equity firms and their LPs, investors using leverage, and the people charged with paying the interest on © 2024 OAKTREE CAPITAL MANAGEMENT, L.P.RESERVED

So, while most depositors can demand their money back at any time, (a) no banks keep enough cash on hand to pay back all their depositors, (b) their main assets don’t pay down in a short timeframe, and (c) if they need cash, it can take them a long time to sell loans – especially if they want a price close to par. Maintaining solvency requires bank managements to be aware of the riskiness of the assets they acquire, among other things. But liquidity is a more transient quality. By definition, no bank can have enough liquidity to meet its needs if enough depositors ask for their money all at once. Managing these issues is a serious task, since it’s a bank’s job to borrow short (from its depositors) and lend long. This mismatch, like most other mismatches, is encouraged by the upward slope of the typical yield curve. If you want to borrow, you’ll find the lowest interest rates at the “short end” of the curve. Thus, you minimize your costs by borrowing for a day or a month . . . but you expose yourself to the risk of rising interest expense, since you haven’t fixed your rate for long. Similarly, if you want to lend (or invest in bonds), you maximize your interest income by lending long . . . but that subjects you to the risk of capital losses if interest rates rise. If you follow the yield curve’s dictates, you’ll always borrow short and lend long, exposing you to the possibility of an SVB-type mismatch. • High leverage – Banks operate with skinny returns on assets.

They pay depositors (or the Fed) a low rate of interest to borrow the funds they need to operate, and they lend or invest those funds at slightly higher rates, earning a modest spread. But they literally make it up on volume. They employ heavy leverage, meaning they can do a lot of business based on little equity capital, thereby translating a low return on assets into a high return on equity. However, having a high ratio of total assets to equity capital means a modest decline in asset prices can wipe out a bank’s equity, rendering it insolvent. There’s no source of meltdown – in any sector – as potentially toxic as the combination of high leverage and an asset/liability mismatch. Banks have them both. © 2023 OAKTREE CAPITAL MANAGEMENT, L.P.RESERVED

Thus, asset ownership – whether related to companies, pieces of companies (equities), or properties – was the place to be. • Falling interest rates brought down the cost of capital for borrowers. As this occurred, any borrowing automatically became more successful than originally contemplated. • And, as I also mentioned in Sea Change, the combined result of the above for investors who bought assets on borrowed money was a double bonanza. Think back to the first of the sea © 2023 OAKTREE CAPITAL MANAGEMENT, L.P.RESERVED

Investors who profited in this period from asset ownership and levered investment strategies may overlook the salutary effect of interest rates on asset values and borrowing costs and instead think the profits stemmed from the inherent merit of their strategies, perhaps with some help from their own skill and wisdom. That is, they may have violated a basic rule in investing: “Never confuse brains and a bull market.” Given the benefits of being on the “moving walkway” during this period, it seems to me it would have required really bad decision-making or really bad luck for a purchase of assets made with borrowed money to have been unsuccessful. Will asset ownership be as profitable in the years ahead as in the 2009-21 period? Will leverage add as much to returns if interest rates don’t decline over time or if the cost of borrowing isn’t much below the expected rate of return on the assets purchased? Whatever the intrinsic merits of asset ownership and levered investment, one would think the benefits will be reduced in the years ahead. And merely riding positive trends by buying and levering may no longer be sufficient to produce success. In the new environment, earning exceptional returns will likely once again require skill in making bargain purchases and, in control strategies, adding value to the assets owned. Lending, credit, or fixed income investing should be correspondingly better off.

In this latter regard, it’s essential to acknowledge that since we haven’t lived through times exactly like the years that lie ahead – and since changes in the economic/financial environment limit the applicability of history – we’re likely to encounter surprises. And if the environment is less favorable, the surprises are likely to be on the downside. Please note, as mentioned earlier, that I’m absolutely not saying interest rates are going back to the high levels from which they’ve come. I have no reason to believe that the recession most people believe lies ahead will be severe or long-lasting. And with valuations high, but not terribly so, I don’t think a stock market collapse can reasonably be predicted. This isn’t a call for dramatically increased defensiveness. Mostly I’m just talking about a reallocation of capital, away from ownership and leverage and toward lending. This isn’t a song I’ve sung often over the course of my career. This is the first sea change I’ve remarked on and one of the few calls I’ve made for substantially increasing investment in credit. But the bottom line I keep going back to is that credit investors can access returns today that: • are highly competitive versus the historical returns on equities, • exceed many investors’ required returns or actuarial assumptions, and • are much less uncertain than equity returns. Unless there are serious holes in my logic, I believe significant reallocation of capital toward credit is warranted.

But with the ability to issue high yield bonds, smaller firms could now acquire larger ones by using heavy leverage, since there was no longer a need to possess or maintain an investment grade rating. This change permitted, in particular, the growth of leveraged buyouts and what’s now called the private equity industry. © 2022 OAKTREE CAPITAL MANAGEMENT, L.P.RESERVED

• They reduce the prospective returns investors demand from investments they’re considering, thereby increasing the prices they’ll pay. This can be seen most directly in the bond market – everyone knows it’s “rates down; prices up” – but it works throughout the investment world. • By lifting asset prices, they create a “wealth effect” that makes people feel richer and thus more willing to spend. • Finally, by simultaneously increasing asset values and reducing borrowing costs, they produce a bonanza for those who buy assets using leverage. I want to spend more time on that last point. Think about a buyer who employs leverage in a declining- rate environment: • He analyzes a company, concludes that he can make 10% a year on it, and decides to buy it. • Then he asks his head of capital markets how much it would cost to borrow 75% of the money. When he’s told it’s 8%, it’s full speed ahead. Earning 10% on three-quarters of the capital that’s borrowed at 8% would lever up the return on the other one-quarter (his equity) to 16%. • Banks compete to make the loan, and the result is an interest rate of 7% instead of 8%, making the investment even more profitable (a 19% levered return). • The interest cost on his floating-rate debt declines over time, and when his fixed-rate debt matures, he finds he can roll it over at 5%. Now the deal is a home run (a 25% levered return, all else being equal).

© 2022 Oaktree Capital Management, L.P. All Rights Reserved Follow us: • a wave of IPOs from money-losing companies; • record issuance of sub-investment grade securities, including risky CCC-rated debt; • debt issuance from companies in volatile industries such as tech and software that lenders are likely to shun in more cautious times; • rising valuation multiples on acquisitions and buyouts; and • shrinking risk premiums. Favorable developments also encourage the increased use of leverage. Leverage magnifies gains and losses, but in bull markets, investors feel sure of gains and disregard the possibility of loss. Under such conditions, few can see a reason not to incur debt – with its piddling interest cost – to increase the payoff from their successes. But putting more debt on investments made at high prices late in the up-cycle is no formula for success. When times turn bad, leverage turns disadvantageous. And when investment banks issue late-cycle debt that they can’t place with buyers, they’re stuck with it. Debt “hung” on banks’ balance sheets is often a “canary in the coal mine” with regard to what’s in store. Since I’m relying on time-worn investment adages, it’s appropriate at this point to invoke the one I consider the greatest regarding investor behavior over cycles: “What the wise man does in the beginning, the fool does in the end.

© 2022 Oaktree Capital Management, L.P. All Rights Reserved Follow us: that the causes of events vary, the consequences of events vary, the form they take varies. But there are things that do recur. For example: • Number one: Generally speaking in the markets, when things have been going well for a few years, people become less risk-averse. When they become less risk-averse, they do riskier things. When the economy eventually turns down, those things produce outsized losses. • Number two: When people are feeling good and things have been going well for a while, people use more leverage. And, eventually, they reach a level of leverage such that they can’t survive in tough times, and they melt down when tough times arrive. • Number three: Because borrowing for the short term is cheaper than borrowing long, people tend to borrow short for long-term projects in order to maximize the delta. But if a bad day comes when you have to refinance your short-term debts because they’re due and the market is closed, you can’t, and you’re out of business. These are themes that we see recur over time. Not exactly the same every time, and with different reasons from time to time. But I do think that themes – mostly relating to psychology – tend to rhyme, you know. The particulars of market mechanics, the use of different forms of fundraising, and different forms of securities – these change all the time: ETFs, algorithmic funds, index funds, senior loans, and high yield bonds.

© 2021 Oaktree Capital Management, L.P. All Rights Reserved Follow us: “they won’t try to predict which miners will find gold; they’ll sell picks and shovels to all of them.” • When GFI gave us their drafts of the marketing materials for that first 1999 fund, there was extensive discussion, in a very Oaktree-like fashion, of the many types of risk they wouldn’t take, such as technological risk and commodity risk. And they’ve stuck with that discipline. • Larry, Richard and Ian also laid out the specific strategies that they would pursue based on the expected industry trends and company behavior. Those strategies are still guiding the Power funds to great success a quarter-century later. The GFI founders were remarkably prescient. • Finally, it’s worth observing that the Power Opportunities group has increased its capital under management only gradually. There can be little doubt that discipline in fundraising has had a favorable impact on investment results. It’s simply an oxymoron to say, “I’ve found an incredible niche where great returns can be earned consistently and with little risk, and it’s infinitely scalable.” That just doesn’t make sense. So, when the $1 billion Power Fund II compiled its net IRR of 59% – without its portfolio companies employing high leverage – I asked the group leaders how much capital they wanted for their next fund. The answer was simple: $1 billion.

But the bill encountered resistance in the House, where so-called progressive Democrats refused to vote for it unless the House first passed a “Build Back Better” bill, with trillions of dollars for safety-net programs unrelated to physical infrastructure. That became the basis for the intricate kabuki theater that played out over the last three months. The infrastructure bill approved by the Senate could have been passed in the House in August. But partisan squabbles imperiled it, since most Republicans didn’t want to give President Biden’s Democratic administration a victory and some progressive Democrats wanted to use their leverage to hold the bill hostage until the moderates voted for theirs. Rather than call a vote immediately on the infrastructure bill, House Speaker Nancy Pelosi (perhaps wanting to placate the progressive members of her Democratic caucus) tied the two bills together, even though the BBB bill had yet to be fleshed out, debated, or “scored” in terms of its effect on the federal budget. Later, under pressure, she agreed in writing to work to pass the infrastructure bill and hold a vote on it by September 27, but she failed to do so (with no consequences). What ensued was a real game of chicken.

• Higher interest rates would raise the cost of servicing the national debt, further swelling the annual deficits (and therefore the national debt). • Larger deficits could make lenders (and foreign buyers) demand still-higher interest rates on U.S. debt securities, creating a negative feedback loop. • If we continue to print enough money to pay the interest and fund the deficit, eventually the value of the dollar and its use as the world’s reserve currency could be called into question. • As we’ve experienced in the past, rapidly rising prices could cause inflationary expectations to become embedded in Americans’ psyches, making the increases self-perpetuating and hard to combat. Further, we should consider the negative aspects of accommodative monetary policy itself: • Fed largesse can be viewed as implying the existence of a “Fed put,” or a guarantee of future bailouts. The consequences can include increased moral hazard (the belief that investors can take risk without consequences) and a diminution of the risk aversion that must be present in order for markets to be safe. • The above conditions can lead businesses and investors to use more leverage, magnifying the potential damage from a slowdown. • As we’ve seen in the last 16 months, the Fed can’t stimulate the economy without increasing the value of the economy. And who receives the benefit? The people who own the economy (i.e., the owners of equities, companies and real estate).

© 2021 Oaktree Capital Management, L.P. All Rights Reserved Follow us: might like to have faster growth in the years ahead than the economy would provide on its own, but I don’t think the long-term rate of growth can be lifted perpetually through monetary and fiscal policy, and certainly not without the risk of negative consequences. To have a healthier allocation of capital, I’d like to see a free market in money, and to me that means interest rates that are “naturally occurring.” Rates held artificially low distort the capital markets, penalizing savers, subsidizing borrowers, lifting asset prices and encouraging increased risk taking and the use of more leverage. Again, I’d prefer to see a Fed that’s reluctant to intervene other than when intervention is essential. * * * In my first memo of the pandemic, I wrote the following about the coronavirus: No one knows much about it, since this is its first appearance. As Harvard epidemiologist Marc Lipsitch said on a podcast on the subject, there are (a) facts, (b) informed extrapolations from analogies to other viruses and (c) opinion or speculation. The scientists are trying to make informed inferences. Thus far, I don’t think there’s enough data regarding the coronavirus to enable them to turn those inferences into facts. (Nobody Knows II, March 3, 2020) Substitute “economists” for “scientists” and “inflation” for “coronavirus,” and I think this paragraph can serve well today.

© 2021 Oaktree Capital Management, L.P. All Rights Reserved Follow us: time-weighted returns or internal rates of return. Oaktree makes no representation, and it should not be assumed, that past performance is an indication of future results. The performance information presented is for funds, accounts and strategies that are not necessarily representative of future Oaktree funds, accounts or strategies, and there can be no assurance that any Oaktree funds or accounts will be able to earn the rates of return indicated herein. Different Oaktree funds, accounts and strategies have different risk profiles and different investment objectives, and therefore, the investments made by certain Oaktree funds or accounts would not necessarily have been appropriate for other Oaktree funds or accounts. The results of each actual fund, account or strategy will differ from each other and from the results represented herein due to differences in asset quality, leverage, geography, property type and other investment-related factors. Indeed, wherever there is the potential for profit, there is also the possibility of loss. The U.S. High Yield Bond – Broad Composite (“Composite”) includes all actual, fully discretionary, fee- paying accounts that focus exclusively on the debt of solvent U.S. and Canadian corporations with an emphasis on senior, cash paying securities rated BB+ to CCC- and are benchmarked to the BB+/CCC- index.

In addition, as noted herein, certain (but not all) of Oaktree’s funds have utilized credit facilities (subscription lines), which has the effect of making fund, aggregate fund and composite level gross and net returns higher than the gross and net returns that would have been presented had drawdowns from partners been initially used to acquire the investment(s). There can be no assurance that future funds and strategies will be able to obtain comparable leverage on commercially reasonable terms. Oaktree Performance Important information about the statements: “When the markets fell sharply in March, our prior caution allowed 9 of our 14 open-end strategies to avoid part of their benchmarks’ declines (before fees).” and “we’re happy to report that 10 of the 14 strategies exceeded their benchmarks in the fourth quarter, allowing 9 of them to do so for the full year (all references to returns are before fees).” The annual performance of the open-end strategies presented below is for the period of 1/1/2020 – 12/31/2020. © 2021 OAKTREE CAPITAL MANAGEMENT, L.P.RESERVED

Meaningful comparisons require access to accurate data and appropriate consideration of strategy, vintage and leverage (in addition to myriad other factors). Unfortunately, we don’t always have access to all of the requisite data of our competitors. Thus, while we are sharing this data that we rely upon internally, we want to be sure you understand the limits of our analysis. As the Preqin database purports to report accurate performance data (though we are obviously not in a position to verify the data they report). The analysis provided herein is derived from that data. Needless to say, our analysis is inherently subjective. Among other things, you might question whether we have appropriately selected our competitors. Due to the limitations of the data we cannot guarantee that the competitive analysis or the investment universe provided herein is fully comparable. Moreover, we are subject to the limitations of the underlying data, which does not always include IRR or other information that might be meaningful to a competitive assessment. In addition, the information presented also does not disclose the investment objectives, risks, fees, or tax features of the peer funds included in the comparison universe, all of which is relevant information for a full comparison. Nevertheless, it is our best attempt to compare our performance and we make it available to you in that spirit and in the hope that you will find it helpful.

Calculation of Assets Under Management References to total "assets under management" or "AUM" represent assets managed by Oaktree and a proportionate amount of the AUM reported by DoubleLine Capital LP ("DoubleLine Capital"), in which Oaktree owns a 20% minority interest. Oaktree's methodology for calculating AUM includes (i) the net asset value (NAV) of assets managed directly by Oaktree, (ii) the leverage on which management fees are charged, (iii) undrawn capital that Oaktree is entitled to call from investors in Oaktree funds pursuant to their capital commitments, (iv) for collateralized loan obligation vehicles ("CLOs"), the aggregate par value of collateral assets and principal cash, (v) for publicly-traded business development companies, gross assets (including assets acquired with leverage), net of cash, and (vi) Oaktree's pro rata portion (20%) of the AUM reported by DoubleLine Capital. This calculation of AUM is not based on the © 2021 OAKTREE CAPITAL MANAGEMENT, L.P.RESERVED

There are a lot of moving parts; most importantly, it has very strong management that I believe will continue to leverage the company’s strong position in the marketplace to develop new avenues of growth. I can’t say what those will be, or how they’ll be valued, but I’m confident the team will continue to add value. Amazon is the classic example; it created a completely new business out of nothing, AWS, that today accounts for a large percentage of the company’s total market value. Selling should be a function of watching how the future develops relative to your expectations and weighing the opportunity as it stands at any point in time against whatever else is out there. H: Okay. I’m convinced. I hope you hold on! © 2021 OAKTREE CAPITAL MANAGEMENT, L.P.RESERVED

Thus, for example, one forecaster who has the earnings of the S&P 500 companies down 120% in Q2 thinks they may rise roughly 80+% in Q3 on a quarter-over-quarter basis (that is, to down just 20% from 2019) and then rise by a further 50% in Q4. And after a decline of 33% in 2020, earnings will rise by 55% in 2021 and exceed what they were in 2019. • Telling people to stay home – and thus causing businesses to close – is the economic equivalent of putting a patient into a coma to facilitate curing a serious disease. The government will provide life support to the economy during the coma and bring the patient out of the coma after the cure has been effected. The economic recovery will be abetted by better news about the disease, but the improvement will mainly be the result of the success of the Fed/Treasury package of rescue and stimulus. These organizations have announced unprecedented expenditures and have indicated that they’ll do whatever else it takes. Actions that were taken after months of deliberation in the Global Financial Crisis have been rolled out in the early weeks of the current episode. Further steps are likely to include everything anyone can think of and be unconstrained as to amount. • The banks are much less vulnerable than they were during the Global Financial Crisis, with only a third of the leverage. Thus concerns for the health of the overall financial system are greatly reduced. © 2020 OAKTREE CAPITAL MANAGEMENT, L.P.RESERVED

© 2020 Oaktree Capital Management, L.P. All Rights Reserved Follow us: reducing their share count and increasing their earnings per share (and perhaps their executive compensation). The result of either or both is to increase the ratio of debt to equity. The more debt a company has relative to its equity, the higher the return on equity will be in good times . . . but also the lower the return on equity (or the larger the losses) in bad times, and the less likely it is to survive tough times. Corporate leverage complicates the issue of lost revenues and profits. Thus we expect to see rising defaults in the months ahead. • Likewise, in recent years, the generous capital market conditions and the search for return in a low-interest-rate world caused the formation of leveraged investment entities. As with leveraged companies, debt increased their expected returns but also their vulnerability. Thus I believe we’re likely to see defaults on the part of leveraged entities, based on price markdowns, ratings downgrades and perhaps defaults on their portfolio assets; increased “haircuts” on the part of lenders (i.e., reduced amounts loaned against a dollar of collateral); and margin calls, portfolio liquidations and forced selling. In the Global Financial Crisis, leveraged investment vehicles like Collateralized Mortgage Obligations and Collateralized Debt Obligations melted down, bringing losses to the banks that held their junior debt and equity.

No, he said, it would only buy government and agency obligations. As mentioned above, a few weeks ago the Fed added investment grade corporates to its buying list, and last week it dropped down to include some high yield securities (BBBs downgraded to BB and some high yield ETFs). It also gave regulatory relief to business developments companies, or BDCs, which buy or make loans to mid-size businesses. In order to help them avoid tripping limits on their activities, the Fed said they can value the loans on their books at December 31 prices. “The SEC is primarily trying to address the issue that a temporary markdown in the fair value of BDC portfolio companies could increase leverage above the regulatory maximum, thus limiting further lending by a BDC. As such, © 2020 OAKTREE CAPITAL MANAGEMENT, L.P.RESERVED

© 2020 Oaktree Capital Management, L.P. All Rights Reserved Follow us: the SEC is allowing BDCs to use an adjusted portfolio value when calculating their asset coverage (leverage) ratio.” (Keefe, Bruyette & Woods, April 9) In other words, we’re in a regulatory wonderland where there’s no pretense that financial statements have to be accurate or current. I was particularly surprised by these latter actions. What’s the Fed’s purpose in buying non- investment grade debt? Does it want to make sure all companies are able to borrow, regardless of their fundamentals? Does it want to protect bondholders from losses, and even mark-to-market declines? Who’ll do the buying for the government and make sure the purchase prices aren’t too high and defaulting issuers are avoided (or doesn’t anyone care)? And why should the SEC provide relief to leveraged investment vehicles? If such an entity proves to be over-leveraged and sees its collateral marked down such that it’s constricted or even liquidated, what’s the loss to society? Why should leveraged investors – ostensibly not systemically important – be protected from pain? In the aftermath of the Global Financial Crisis, the Fed and Treasury undertook a number of actions to encourage price discovery, rekindle risk-bearing and reopen markets. They worked well, their goals were accomplished, and the U.S. recovery from the GFC was swift and strong.

(Of course, we can debate whether the willingness to bear risk snapped back too fast and too far.) But some of these things were done through encouraging the operation of market mechanisms, not direct action. Now bonds are being bought and rules waived. Is there a point at which these things become undesirable? Most of us believe in the free-market system as the best allocator of resources. Now it seems the government is happy to step in and take the place of private actors. We have a buyer and lender of last resort, cushioning pain but taking over the role of the free market. When people get the feeling that the government will protect them from unpleasant financial consequences of their actions, it’s called “moral hazard.” People and institutions are protected from pain, but bad lessons are learned. A company uses its cash and perhaps borrows more to repurchase its shares. A corporate acquiror chooses to use more leverage rather than less. Or the organizer of a REIT or CLO takes on more debt in order to amplify its returns. In each case, the chosen tactic will magnify profits if things go well, but it’ll also magnify losses if things go poorly and reduce the probability of surviving tough times. If these parties get to enjoy the fruits of their actions when they’re successful but are protected from loss when they fail, risk-taking is encouraged and risk aversion is suppressed.

There’s an old saying – variously attributed – to the effect that “capitalism without bankruptcy is like Catholicism without hell.” It appeals to me strongly. Markets work best when participants have a healthy fear of loss. It shouldn’t be the role of the Fed or the government to eradicate it. Some people argue these days that there’s no way those who took on leverage that turned out to be excessive could have been expected to anticipate a pandemic and the resultant damage to the economy. Thus, the argument goes, the jam the government is rescuing them from “isn’t their fault,” meaning the bailout isn’t unreasonable. As I wrote in Which Way Now?, I understand they aren’t guilty of having ignored a likely risk. But unlikely (and even unforeseeable) things happen from time to time, and investors and businesspeople have to allow for that possibility and expect to © 2020 OAKTREE CAPITAL MANAGEMENT, L.P.RESERVED

© 2020 Oaktree Capital Management, L.P. All Rights Reserved Follow us: • Negative economic and corporate developments, collapsing markets and rising fear caused a credit crunch in which financing became impossible to obtain. • The combination of economic weakness and the unavailability of financing led to vastly increased defaults and bankruptcies. • Asset prices cratered. • Companies and investment entities marked by asset/liability mismatches and/or high levels of leverage experienced margin calls and meltdowns. • The downward spiral seemed unstoppable. • Pessimism ran rampant, leading to soaring risk aversion. • This led to panic selling of assets and rendered most investors absolutely unwilling to buy. • Because of all the above, it was possible to purchase assets at prices from which extremely high returns could be achieved, often with low attendant risk. Now, contrast that with the events of 2020. In mid-February, developments regarding the coronavirus pandemic and the lockdown implemented to fight it began to hammer the markets. Prices for equities and credit fell, and the mood turned darkly negative. From the all-time high reached on February 19, the S&P 500 fell 34% in only 33 days. The prices of high yield bonds and leveraged loans were hard-hit as well. Security issuance stopped cold. The pieces were in place for a crisis just like those described above, and things were moving in that direction in March.

No, I’ll Pay You! Historically – until the European Central Bank took the rate on its credit facility to -0.10% in 2014 – borrowers paid interest to the people from whom they borrowed money. But in the recovery from the Global Financial Crisis, interest rates went negative for the first time in recent history, meaning some lenders paid borrowers for the privilege of lending them money. I had my first direct brush with negative interest rates in 2014, when I was making an investment in Spain. The closing was due to take place on Monday, and I wired funds on the prior Wednesday so as to be in position to close. The following conversation ensued with my Spanish lawyer: Carlos: The money has arrived. What should I do with it between now and Monday? HM: Put it in the bank. © 2019 OAKTREE CAPITAL MANAGEMENT, L.P.RESERVED

So the second-level thinker wonders how bad the outlook is, how much worse it might have gotten without the rate cut, and whether the cut will be sufficient to avert a slowdown. In 2006, on the way to the Global Financial Crisis, delinquencies on sub-prime mortgages began to rise. The trend became more noticeable in mid-2007, leading to falling prices for mortgage-backed securities; margin calls for mortgage-backed-securities funds (from banks that had given them leverage); and, eventually, fund meltdowns. Most prominently, on July 31, 2007, two mortgage- backed-securities funds managed by Bear Stearns filed for bankruptcy. Investors wanted help, and the Fed rode to the rescue. On September 18, it cut the fed funds rate by 50 basis points, from 5.25% to 4.75%, and issued a statement that included the following: Today’s action is intended to help forestall some of the adverse effects on the broader economy that might otherwise arise from the disruptions in financial markets and to promote moderate growth over time. . . . Developments in financial markets since the Committee’s last regular meeting have increased the uncertainty surrounding the economic outlook. The Committee will continue to assess the effects of these and other developments on economic prospects and will act as needed to foster price stability and sustainable economic growth. The rate cut and message were warmly received, with the S&P 500 rising more than 6% over the next two weeks.

(The New York Times, June 26) Why would Trump want lower rates? Here are a few possible explanations:  He’s a real estate guy, and the real estate industry lives on high leverage.  Trump has been a substantial borrower for much of his life, so for him low rates are “all good.”  Right now Trump is tightly focused on getting reelected, and ensuring economic growth and a rising stock market over the next 16 months is one of the best things he can do to make that a reality.  Along those lines, if reelection is his main goal, he may be relatively indifferent as to what happens after Election Day 2020, when the scorecard he cares about most will be closed out. Here’s an expression of Trump’s position on rates: “Our country’s doing unbelievably well economically,” he told reporters Friday. Yet even as Mr. Trump celebrated the robust hiring numbers, he called again for the Federal Reserve to cut interest rates – a step that would ordinarily suggest worries about the economy’s direction. Growth “would be like a rocket ship” if the Fed acted, he declared. (The New York Times, July 6) On the basis of the above, one might conclude that Trump thinks rates should always be low. But there was at least one instance when he thought rates were being held too low: In late 2015 then-candidate Donald Trump accused Janet Yellen, chair of the Federal Reserve, of being part of a political conspiracy. Yellen, he insisted, was keeping © 2019 OAKTREE CAPITAL MANAGEMENT, L.P.RESERVED

 When low rates penalize savers by reducing the returns available on safe instruments like cash, money market funds, savings accounts, Treasury securities and high grade bonds, savers’ alternative to accepting lower incomes is to assume increased risk in pursuit of the higher returns they used to earn safely.  Thus low rates can lead to investment in undeserving companies and shaky securities, encourage the use of excessive leverage, and create asset bubbles that eventually can burst.  Ultimately, investors’ tendency to reach for yield and assume excessive risk can introduce risk to overall financial stability.  Finally, but very importantly, when interest rates are low, central banks don’t have at their disposal as much of their best tool for stimulating economies: the ability to cut rates. The following is from a report from RDQ Economics dated June 27: What seems lost in the policy assessment is a careful discussion of the risks of overly accommodative monetary policy. Powell did say this week, “we are also mindful that monetary policy should not overreact to any individual data point or short-term swing in sentiment. Doing so would risk adding even more uncertainty to the outlook.” However, our view is that Powell’s observation of the downside of a dovish overreaction is an inadequate assessment of the risk from unnecessarily adding monetary accommodation at this time. . . .

”  The potential catalysts for decline that we have to worry about most may be the unknown ones. And although I read recently that bull markets don’t die of old age or collapse of their own weight, I think sometimes they do (a dollar for anyone who can identify the catalyst for the collapse of the bull market and tech bubble in 2000 – it’s not easy). The bottom line of the above is that some people are excited about the fundamentals, and others are wary of asset prices. Both positions have merit, but as is often the case, the hard part is figuring out which one to weight more heavily. As I wrote in September, most people (and certainly the media) want definite answers: in or out? buy or sell? risk-on or risk-off? But it’s rare for answers that simple to be correct. There’s a wide range of possible stances that investors might adopt. At one end of the spectrum there’s maximum aggressiveness (100% invested in high-beta, high-risk assets, or maybe more than 100% through the use of leverage), and at the other there’s maximum defensiveness (100% cash, or perhaps being net short). Most investors are never either of those. And I certainly wouldn’t be either of them today; I’d be someplace in between. That’s easy to say. But where? Closer to the bullish end of the spectrum or the bearish end? Or balancing the two equally? My answer today, as readers know, is that I would favor the defensive or cautious part of the spectrum.

The above factors tell me this is not such a time. A Case In Point: Direct Lending In the years immediately following the Crisis, the banks – which remained traumatized and in many cases were marked by low capital ratios – were reluctant to do much lending. Thus a few bright credit investors began to organize funds to engage in “direct lending” or “private lending.” With the banks hamstrung by regulations and limited capital, non-bank entities could be selective in choosing their borrowers and could insist on high interest rates, low leverage ratios and strong asset protection. Not all investors participated in the early days of 2010-11. But many more got with the program in later years, after private lending had caught on and more managers had organized direct-lending funds to accommodate them. As the Wall Street Journal wrote on August 13: The influx of money has led to intense competition for borrowers. On bigger loans, that has driven rates closer to banks’ and led to a loosening of credit terms. For smaller loans, “I don’t think it could become any more borrower friendly than it is today,” said Kent Brown, who advises mid-sized companies on debt at investment bank Capstone Headwaters. © 2018 OAKTREE CAPITAL MANAGEMENT, L.P. ALL RIGHTS RESERVED.

© 2018 Oaktree Capital Management, L.P. All Rights Reserved Follow us:  Capital equipment company A issued debt to finance its acquisition by a private equity fund. “While we thought the initial price talk was far too tight, the deal was oversubscribed and upsized, and the pricing was tightened by 25 bps. Final terms were highly aggressive with covenant-lite structure, uncapped adjustments to EBITDA, and a large debt incurrence capacity.” The company missed expectations in the first two quarters after issuance, in reaction to which the first lien loan traded down by as much as five points and the high yield bonds traded down by as much as 15.  The European market isn’t insulated from the trend toward generosity. Company B is a good services company, albeit with exposure to cyclical end-markets; is smaller than its peers; has lower margins, higher leverage and limited cash-generation ability; and went through a restructuring a few years ago. Nevertheless, on the back of adjusted EBITDA equal to 150% of its reported figure, the company was able to issue seven-year bonds paying just over 5%.  Energy product company C recently went public. Despite a retained deficit of $2.4 billion and an S-1 stating “we have incurred significant losses in the past and do not expect to be profitable for the foreseeable future,” its shares were oversubscribed at the IPO price and are now selling 67% higher.

One equity analyst says that’s a reasonable valuation, since it’s 5x estimated 2020 revenues. Another has a target price 25% below the current price, although to get to that valuation the analyst assumes the company will be able to expand its gross margin by 30% a year for the next 12 years and be valued at 6x EBITDA in 2030.  Over the last two years, company D has spent an amount on buybacks equal to 85% of a year’s EBITDA. In part because of the buybacks, the company now has much more debt than it did two years ago. In contrast to the last two years, we estimate that in the seven preceding years, it spent only one-tenth as much on buybacks as in the last two years, at an average purchase price 85% below the more recent average.  A buyout fund just bought company E, a terrific company, for 15x EBITDA, a very high “headline figure.” The price is based on adjusted EBITDA which is 125% of reported EBITDA; thus the transaction price equates to 19x reported EBITDA. Stated leverage is 7x adjusted EBITDA, meaning 9x reported EBITDA. “We aren’t saying this will wind up being a bad deal. Just saying that IF this ends up being a bad deal, no one will be surprised. Everyone will say, with the benefit of hindsight, ‘they paid way too much and put way too much debt on the balance sheet, and it was doomed out of the gate.’ ”  Company F earns substantial EBITDA, but 60% comes from a single unreliable customer, and its growth is constrained by geography.

We arrived at a price where we thought it would constitute a good investment for us. But the owners wanted twice as much . . . and they got it from a buyout fund. “We are generally seeing financial sponsors being very aggressive, pricing to perfection with very little room for error, on the back of very liberal lending practices by banks and non-traditional lenders. We all know how this will end.”  A year ago, a buyout fund financed the acquisition of company G by one of its portfolio companies with 100% debt and took out a dividend for itself. The deal was marketed with an adjusted EBITDA figure that was 190% of the company’s reported EBITDA. Based on the adjusted figure, total leverage was more than 7x, and based on the reported figure it was 13.5x. The bonds are now trading above par, and the yield spread to worst on the first lien notes is below 250 bps.  Company H is a good, growing company that we were ready to exit, and our bankers sent out 100 “teasers.” We received 35 indications of interest: three from strategic buyers and 32 from financial sponsors. “The strategic buyers offered the lowest valuations; it’s always a big warning sign when financial sponsors with no hope of synergies are offering prices much © 2018 OAKTREE CAPITAL MANAGEMENT, L.P. ALL RIGHTS RESERVED.

© 2018 Oaktree Capital Management, L.P. All Rights Reserved Follow us: higher than strategics.” We received four purchase offers from buyout funds, one with the price left blank. We ended up selling at 14x EBITDA, with total leverage of more than 7x.  In 2017, investors bought over $10 billion of debt from Argentine and Turkish local- currency-earning corporates that now trades, on average, 500 bps wider than at issuance (e.g., at an 11% yield today versus 6% at issue).  The high point in emerging market debt (or was it the low point?) was Argentina’s ability in June 2017 to issue $2.75 billion of oversubscribed 100-year bonds despite a financial history marked by crises in 1980, 1982, 1984, 1987, 1989 and 2001. The bond was priced at 90 for a yield of 7.92%. Now it’s trading at 75, implying a mark-down of 17% in 16 months. Of particular note, David Rosenberg, Oaktree’s co-portfolio manager for U.S. high yield bonds, provides an example of post-Crisis restraints being loosened. The government’s Leverage Lending Guidelines, “introduced in 2013 to curb excessive risk-taking, capped leverage at 6x – subject to certain conditions – and contributed to less aggressive dealmaking [sic] among regulated banks. . . .” Now the head of the Office of the Comptroller of the Currency has indicated, “it’s up to the banks to decide what level of risk they are comfortable with in leveraged lending. . . .

© 2018 Oaktree Capital Management, L.P. All Rights Reserved Follow us: later, when the buying has stopped and the price has receded. It might be possible to sell stock today at $20.03 or $20.04 that can be bought back at $20.00 or 20.01 in a few days.  Thus the quant provides liquidity that otherwise wouldn’t exist and is willing to carry positions overnight. In exchange the quant gets a couple pennies more for the stock he supplies than he’ll have to pay to buy it back. We might say that for the most part, the stat arb computer responds to disequilibria between the price of one stock and the prices of other stocks or the market as a whole, and it acts on the assumption that the relationships will revert to normal. The pennies made aren’t a big deal (perhaps a 0.1% profit in the above example), and as Renaissance Technologies said in a statement to a Senate subcommittee in 2014 concerning its core Medallion fund, “The model developed by Renaissance . . . makes predictions that are profitable only slightly more often than not.” But if you do it often enough and on enough leverage, stat arb can produce meaningful returns on equity. This is like what Long-Term Capital Management did in the late 1990s, looking for statistical divergences that could be arbitraged. One of its executives described what it did as going around the world picking up nickels and dimes.

© 2018 Oaktree Capital Management, L.P. All Rights Reserved Follow us: Thus the best we can do is turn cautious when the situation becomes precarious. We never know for sure when – or even whether – “precarious” is going to turn into “collapse.” To close, I’m going to recycle two of the final paragraphs of The Race to the Bottom. Doing so permits me to provide an excellent example of history’s tendency to rhyme: Today’s financial market conditions are easily summed up: There’s a global glut of liquidity, minimal interest in traditional investments, little apparent concern about risk, and skimpy prospective returns everywhere. Thus, as the price for accessing returns that are potentially adequate (but lower than those promised in the past), investors are readily accepting significant risk in the form of heightened leverage, untested derivatives and weak deal structures. . . . This memo can be recapped simply: there’s a race to the bottom going on, reflecting a widespread reduction in the level of prudence on the part of investors and capital providers. No one can prove at this point that those who participate will be punished, or that their long-run performance won’t exceed that of the naysayers. But that is the usual pattern. It’s now eleven years later, but I can’t improve on that. I’m absolutely not saying people shouldn’t invest today, or shouldn’t invest in debt. Oaktree’s mantra recently has been, and continues to be, “move forward, but with caution.

But in 1998, LTCM’s enormously levered portfolio encountered an improbably long period in which, rather than converging, the relationships diverged further. Mark-to-market losses caused Long-Term’s lenders to require the posting of additional capital; unable to do so, the fund melted down; and securities industry leaders had to take on its portfolios. It turned out that LTCM had been picking up nickels and dimes in front of a steamroller, and the steamroller caught up with it. Among the lessons learned in the LTCM experience were that (a) the opportunities for stat arb are limited in size, (b) the capital directed at it must likewise be limited, (c) the leverage employed must be reasonable in order for the investor to survive those periods when historic relationships and probabilities fail to hold, and (d) likewise, it’s important to appropriately hedge out the market’s overall directional risk. * * * Quantitative investors program their computers to emulate behavior that was profitable in the past or that is expected to be profitable in the future. In other words, they set rules or formulas for their computers to live by. The key question is whether, in a competitive, dynamic and interconnected arena like investing, the route to profitability can be captured in a formula, and whether changes in the investment environment (perhaps caused by the very implementation of the formula) won’t negate the formula’s effectiveness. Just the other day, I got an email from Rosalie J.

© 2017 Oaktree Capital Management, L.P. All Rights Reserved Follow us: Memo to: Oaktree Clients From: Howard Marks Re: Lines in the Sand In my 2016 year-end review, which went only to clients, I included a discussion of the use of subscription lines by closed-end funds in areas such as private equity, real estate, distressed debt and private credit. It’s my impression that their use has become fairly pervasive in recent years, and in response to clients’ requests and market trends, Oaktree has utilized subscription lines in some of its newer funds. That year-end note prompted some interesting and spirited discussion of lines and their merit and effect. Thus I decided to write this memo on the topic for general circulation. How Do Subscription Lines Work? As I wrote in the year-end review, subscription lines are bank loans extended to funds that enable them to use borrowed money, rather than LP capital, to make early investments or pay fees and expenses. While there is no universal description, I believe it’s safe to say in general that subscription lines:  are limited as a percentage of the LPs’ capital commitments. (Commitments from the most creditworthy LPs earn a 90% advance rate, and commitments from lesser credits earn lower advance rates or, in some cases, zero),  are secured by the LPs’ capital commitments, and  generally must be repaid in the early or middle part of the fund’s life (unless extended), although terms are beginning to lengthen.

 The use of borrowed money can reduce or even eliminate the deleterious impact on early returns of the so-called “J-curve.” The J-curve results from (a) the fact that in a fund’s early years, management fees are usually charged on total committed capital, while a relatively small percentage of the capital has been put to work, and (b) the tendency of private investments to take a while to show results.  Over the course of a fund’s life, LP capital will typically be called for investments or to repay the borrowings under the subscription line. This will cause the ratio of subscription line capital employed to LP capital to decline. As a result, the fund’s IRR will retreat from its elevated early level and move down toward what it would have been if the fund hadn’t employed a subscription line. However, all other things being equal, the fund’s lifetime IRR will remain higher than it otherwise would have been, since the impact of using the line will taper off but not reverse.  Finally, any committed capital that hasn’t been called because of borrowing under the line will remain in the hands of the LPs. Thus any return the LPs earn on the uncalled capital in excess of their share of the fund’s subscription line costs will be additive to their results. What about the negatives?  If a fund finances investments by borrowing under a subscription line, interest and expenses will be paid that wouldn’t have been paid if LP capital had been called instead.

© 2017 Oaktree Capital Management, L.P. All Rights Reserved Follow us: return. You want to take risk when others are fleeing from it, not when they’re competing with you to do so. Do you see any differences between then and now? Is there any need to redo this description? Not for me; I think “ditto” will suffice. I’ll simply go on to borrow the conclusion from “The Race to the Bottom” (February 2007): Today’s financial market conditions are easily summed up: There’s a global glut of liquidity, minimal interest in traditional investments, little apparent concern about risk, and skimpy prospective returns everywhere. Thus, as the price for accessing returns that are potentially adequate (but lower than those promised in the past), investors are readily accepting significant risk in the form of heightened leverage, untested derivatives and weak deal structures. The current cycle isn’t unusual in its form, only its extent. There’s little mystery about the ultimate outcome, in my opinion, but at this point in the cycle it’s the optimists who look best. The Seeds for a Boom My son Andrew worked extensively with me in preparing this memo. We particularly enjoyed making a list of the elements that typically form the foundation for a bull market, boom or bubble. We concluded that some or all of the following are necessary conditions. A few will give us a bull market.

” In short, as I wrote in the memo, I believe the market is “not a nonsensical bubble – just high and therefore risky.” I wouldn’t use the word “bubble” to describe today’s general investment environment. It happens that our last two experiences were bubble-crash (1998-2002) and bubble-crash (2005-09). But that doesn’t mean every advance will become a bubble, or that by definition it will be followed by a crash.  Current psychology cannot be described as “euphoric” or “over-the-moon.” Most people seem to be aware of the uncertainties that are present and of the fact that the good times won’t roll on forever.  Since there hasn’t been an economic boom in this recovery, there doesn’t have to be a major bust.  Leverage at the banks is a fraction of the levels reached in 2007, and it was those levels that gave rise to the meltdowns we witnessed.  Importantly, sub-prime mortgages and sub-prime-based mortgage backed securities were the key ingredient whose failure directly caused the Global Financial Crisis, and I see no analog to them today, either in magnitude or degree of dubiousness. It’s time for caution, as I wrote in the memo, not a full-scale exodus. There is absolutely no reason to expect a crash.

© 2017 Oaktree Capital Management, L.P. All Rights Reserved Follow us: Importantly, organizers wanting their “smart” products to reach commercial scale are likely to rely heavily on the largest-capitalization, most-liquid stocks. For example, having Apple in your ETF allows it to get really big. Thus Apple is included today in ETFs emphasizing tech, growth, value, momentum, large-caps, high quality, low volatility, dividends, and leverage. Here’s what Barron’s had to say earlier this month: With cap-weighted indexes, index buyers have no discretion but to load up on stocks that are already overweight (and often pricey) and neglect those already underweight. That’s the opposite of buy low, sell high. The large positions occupied by the top recent performers – with their swollen market caps – mean that as ETFs attract capital, they have to buy large amounts of these stocks, further fueling their rise. Thus, in the current up-cycle, over-weighted, liquid, large-cap stocks have benefitted from forced buying on the part of passive vehicles, which don’t have the option to refrain from buying a stock just because its overpriced. Like the tech stocks in 2000, this seeming perpetual motion machine is unlikely to work forever. If funds ever flow out of equities and thus ETFs, what has been disproportionately bought will have to be disproportionately sold.

© 2017 Oaktree Capital Management, L.P. All Rights Reserved Follow us:  That means when the fund reaches $100 billion, SoftBank will have put up only 28% of the capital but will own 50% of the equity. Adding in management fees and carried interest, its 28% of the capital may give it 60-70% of the gains.  Even the private equity industry – with its willingness to take risk – has traditionally shied away from piling debt on technology companies (although less so lately). SoftBank doesn’t hesitate to lever its tech investments.  The preferred units will pay a 7% annual coupon. Lending money to a tech fund at that modest rate apparently is part of the price demanded of the LPs for an opportunity to invest in the fund’s equity. I can imagine the sales pitch about how lucky the LPs are to get a chance to provide leverage for their own investment, but I doubt I’d be convinced.  Finally, as the Financial Times wrote on June 11: While the preferred unit holders will eventually receive their principal back [plus 7% per year], they will only receive [an equity] return for the equity portion of their investment in the fund. All outside backers of the fund are receiving 62 per cent in preferred units and the rest in equity, allowing them to reduce their downside risk, while still generating a good return. Sounds good on the surface. But how much does this diversion of the investors’ capital into preferred units really reduce their downside risk?

Since senior loans had been used to fund buyouts with purchase prices at high multiples of cash flow, investors became concerned about the issuers’ ability to service them, and especially to refinance them when they came due (since the capital markets had slammed shut). Loan prices fell to levels never seen before in the absence of a default; whereas non-distressed senior loans had rarely sold below 95 in the past, now they fell to the 80s, and then to the 60s. Because of the collapsing prices, “market-value” CLOs received margin calls they couldn’t meet, and banks seized portfolios and liquidated them in overnight BWIC (bid-wanted-in- competition) transactions. The indiscriminate selling put further pressure on prices, leading to more margin calls and more BWICs: another prototypical negative feedback loop. The senior loan index was down 29% in 2008. That exceeded the 25% decline of the high yield bond index. Why would senior debt fall more during a crisis than junior debt? The answer is that senior loans had been ground zero for buying with leverage (and thus for margin calls and forced selling) whereas high yield bonds had not. The key questions were rarely asked while things melted down: what were the loans worth, and would they pay? That depended on the outlook for defaults, but in late 2008 few people felt they could assess it or could take the time required to do so.

I want to highlight Krugman’s reference to “psychological contagion.” It’s interesting in this regard that, last week, the world’s stock markets saw the following declines: S&P 500 – 6.0%, FTSE 100 – 5.3%, DAX – 8.3% and Nikkei – 7.0%. I consider it highly unlikely that such uniform declines were the result of independent, objective analysis of the impact of events on each economy and company. Rather, I think they show the extent to which markets are linked by their investors’ shared psychology. So what about the likelihood of another 2008-style crash? The bottom line for me is that a rerun of the Global Financial Crisis isn’t in the cards:  We haven’t had a boom (either in the economy or in the stock market), so I don’t think we’re fated to have a bust. Because most businesses have been particularly loath to expand their facilities, I don’t think they’ll be slammed if revenues flatten or turn down.  The leverage in the private sector has been reduced. This is particularly true of the banks, where leverage has gone from the region of 30+ times equity before the crisis to very low double digits today. And, of course, banks are now barred from investing adventurously for their own account.  Finally, the main villain in the crisis was sub-prime mortgage backed securities. The raw material – the underlying mortgages – was unsound and often fraudulent. The structured mortgage vehicles were highly levered and absurdly highly rated.

But more often, given the herd mentality in markets, “everyone” wants to either sell or buy at once. There’s an old saying to the effect that “In times of crisis all correlations go to one.” The prices of everything move in unison during crises because investors are driven by mob psychology, not fundamentals. Thus – and for the same reason – in times of crisis liquidity often goes to zero.  Usually, as described above, it’s either hard to buy but easy to sell, or hard to sell but easy to buy. Sometimes, however, when everyone’s confused and intimidated, the market freezes up and it can be hard to do both. For example, after securities backed by sub-prime mortgages were thoroughly impugned in the crisis of 2007-08, there was a total lack of trading. The fact that the “last trade” occurred months ago made it hard for potential buyers and sellers to feel confident regarding what a fair price might be. I believe it was for this reason that the U.S. Treasury organized the Public Private Investment Partnership program, under which nine investment managers raised equity capital from clients for investment in mortgage backed securities, with the Treasury matching the equity and then supplying an equal amount of zero-cost leverage. The goal was to cause trading to occur, and with it “price discovery.” After transactions resumed, buyers and sellers had a better idea what a fair price was, so trading and liquidity increased.

© Oaktree Capital Management, L.P. All Rights Reserved illusory, fleeting and unreliable, and it works (like a Ponzi scheme) until markets freeze up and the promise of liquidity is tested in tough times. Some hedge funds provided an example in the last crisis. They raised capital with which to buy assets of uncertain liquidity, sometimes using leverage, and they promised investors the ability to withdraw their money quarterly or annually. But when the end of 2008 rolled around, the desire of LPs for liquidity overwhelmed the capacity of the marketplace to absorb the assets that were for sale (or perhaps the GPs wisely refused to sell because a fair price couldn’t be obtained). When that occurred, the funds told LPs they couldn’t have the liquidity they’d been promised. Illiquid assets went into locked-up “side pockets,” and “gates” came down delaying the effective dates of withdrawals. These little-known provisions gave LPs an unpleasant surprise, demonstrating that in a crisis, the promise of withdrawal from a vehicle holding illiquid assets can easily turn out to be too good to be true.  People often think about liquidity constraints as relating to specific assets; they don’t necessarily think about the knock-on effects of illiquidity from asset to asset and market to market.

© Oaktree Capital Management, L.P. All Rights Reserved The bottom line is unambiguous. Liquidity can be transient and paradoxical. It’s plentiful when you don’t care about it and scarce when you need it most. Given the way it waxes and wanes, it’s dangerous to assume the liquidity that’s available in good times will be there when the tide goes out. What can an investor do about this unreliability? The best preparation for bouts of illiquidity is:  buying assets, hopefully at prices below durable intrinsic values, that can be held for a long time – in the case of debt, to its maturity – even if prices fall or price discovery ceases to take place, and  making sure that investment vehicle structures, leverage arrangements (if any), manager/client relationships and performance expectations will permit a long-term approach to investing. These are the things we try to do. And the worst defenses against illiquidity – or, better said, the approaches that make you most dependent on the availability of liquidity – are (a) employing trading strategies under which you buy things because of how you think they’ll perform in the short run, not what they’ll be worth in the long run, (b) being focused on what the market says your assets are worth, not what your analysis shows them to be worth, and (c) buying with leverage that exposes you to the risk of a margin call in a declining market.

Here’s how I put it last year in “Dare to Be Great II”:  If you invest, you will lose money if the market declines.  If you don’t invest, you will miss out on gains if the market rises.  Market timing will add value if it can be done right.  Buy-and-hold will produce better results if timing can’t be done right.  Aggressiveness will help when the market rises but hurt when it falls.  Defensiveness will help when the market falls but hurt when it rises.  If you concentrate your portfolio, your mistakes will kill you.  If you diversify, the payoff from your successes will be diminished.  If you employ leverage, your successes will be magnified.  If you employ leverage, your mistakes will be magnified. Each of these pairings indicates symmetry. None of the tactics listed will add value if it’s right but not subtract if it’s wrong. Thus none of these tactics, in and of itself, can hold the secret to dependably above average investment performance. There’s only one thing in the investment world that isn’t two-edged, and that’s “alpha”: superior insight or skill. Skill can help in both up markets and down markets. And by making it more likely that your decisions are right, superior skill can increase the expected benefit from concentration and leverage. But that kind of superior skill by definition is rare and elusive. . . . © OAKTREE CAPITAL MANAGEMENT, L.P. ALL RIGHTS RESERVED.

 Defensiveness will help when the market falls but hurt when it rises.  If you concentrate your portfolio, your mistakes will kill you.  If you diversify, the payoff from your successes will be diminished.  If you employ leverage, your successes will be magnified.  If you employ leverage, your mistakes will be magnified. Each of these pairings indicates symmetry. None of the tactics listed will add value if it’s right but not subtract if it’s wrong. Thus none of these tactics, in and of itself, can hold the secret to dependably above average investment performance. There’s only one thing in the investment world that isn’t two-edged, and that’s “alpha”: superior insight or skill. Skill can help in both up markets and down markets. And by making it more likely that your decisions are right, superior skill can increase the expected benefit from concentration and leverage. But that kind of superior skill by definition is rare and elusive. The goal in investing is asymmetry: to expose yourself to return in a way that doesn’t expose you commensurately to risk, and to participate in gains when the market rises to a greater extent than you participate in losses when it falls. But that doesn’t mean the avoidance of all losses is a reasonable objective. Take another look at the goal of asymmetry set © OAKTREE CAPITAL MANAGEMENT, L.P. ALL RIGHTS RESERVED.

© Oaktree Capital Management, L.P. All Rights Reserved And some investment strategies don’t permit full diversification because of the limitations of their subject markets. Thus problems – if and when they occur – will be bigger per se.  Especially given today’s low interest rates, borrowing additional capital to enhance returns is another way to potentially increase returns. But doing so introduces leverage risk. Leverage adds to risk two ways. The first is magnification: people are attracted to leverage because it will magnify gains, but under unfavorable outcomes it will magnify losses instead. The second way in which leverage adds to risk stems from funding risk, one of the classic reasons for financial disaster. The stage is set when someone borrows short-term funds to make a long-term investment. If the funds have to be repaid at an awkward time – due to their maturity, a margin call, or some other reason – and the purchased assets can’t be sold in a timely fashion (or can only be sold at a depressed price), an investment that might otherwise have been successful can be cut short and end in sorrow. Little or nothing may remain of the sale proceeds once the leverage has been repaid, in which case the investor’s equity will be decimated. This is commonly called a meltdown. It’s the primary reason for the saying, “Never forget the six-foot- tall man who drowned crossing the stream that was five feet deep on average.

” In times of crisis, success over the long run can become irrelevant.  When credit risk, illiquidity risk, concentration risk and leverage risk are borne intelligently, it is in the hope that the investor’s skill will be sufficient to produce success. If so, the potential incremental returns that appear to be offered as risk compensation will turn into realized incremental returns (per the graphic at the top of page 6). That’s the only reason anyone would do these things. As the graphic at the bottom of page 6 illustrates, however, investing further out on the risk curve exposes one to a broader range of investment outcomes. In an efficient market, returns are tethered to the market average; in an inefficient market, they’re not. Inefficient markets offer the possibility that an investor will escape from the “gravitational pull” of the market’s average return, but that can be either for the better or for the worse. Superior investors – those with “alpha,” or the personal skill needed to achieve outsized returns for a given level of risk – have scope to perform well above the mean return, while inferior investors can come out far below. So hiring an investment manager introduces manager risk: the risk of picking the wrong one. It’s possible to pay management fees but get decisions that detract from results rather than add. Some or all of the above risks are potentially entailed in our new credit strategies.

Parsing them allows investors to choose among the strategies and accept the risks they’re more comfortable with. The process can be quite informative. Our oldest “new strategy” is Enhanced Income, where we use leverage to magnify the return from a portfolio of senior loans. We think senior loans have the lowest credit risk of anything Oaktree deals with, since they’re senior-most among their issuer’s debt and historically have produced very few credit losses. Further, they’re among our most liquid assets, meaning we face relatively little illiquidity risk, and being active in a broad public market permits us to diversify, reducing concentration risk. Given the relatively high degree of safety stemming from these loans’ seniority, returns aren’t overly dependent on the presence of alpha, meaning Enhanced Income entails less manager risk than some other strategies. But to have a chance at the healthy return we’re pursuing in Enhanced Income requires us to take some risk, and what we’re left with is leverage risk. The 3-to-1 leverage in Enhanced Income Fund II will magnify the negative impact of any credit losses (of course we hope there won’t be many). However, we’re not worried about a meltdown, since the current environment allows us to avoid funding risk; we © OAKTREE CAPITAL MANAGEMENT, L.P. ALL RIGHTS RESERVED.

 We hear a lot about “worst-case” projections, but they often turn out not to be negative enough. What forecasters mean is “bad-case projections.” I tell my father’s story of the gambler who lost regularly. One day he heard about a race with only one horse in it, so he bet the rent money. Half way around the track, the horse jumped over the fence and ran away. Invariably things can get worse than people expect. Maybe “worst-case” means “the worst we’ve seen in the past.” But that doesn’t mean things can’t be worse in the future. In 2007, many people’s worst-case assumptions were exceeded.  Risk shows up lumpily. If we say “2% of mortgages default each year,” and even if that’s true when we look at a multi-year average, an unusual spate of defaults can occur at a point in time, sinking a structured finance vehicle. Ben Graham and David Dodd put it this way: “. . . the relation between different kinds of investments and the risk of loss is entirely too indefinite, and too variable with changing conditions, to permit of sound mathematical formulation. This is particularly true because investment losses are not distributed fairly evenly in point of time, but tend to be concentrated at intervals . . .” (Security Analysis, 1940 Edition). It’s invariably the case that some investors – especially those who employ high leverage – will fail to survive at those intervals.

© Oaktree Capital Management, L.P. All Rights Reserved can (a) borrow for a term that exceeds the duration of the underlying investments and (b) do so without the threat of margin calls related to price declines. Strategic Credit, Mezzanine Finance, European Private Debt and Real Estate Debt are the other four components of our “ten percent solution.”  All four entail some degree of credit risk, illiquidity risk (they all invest heavily or entirely in private debt) and concentration risk (as their market niches offer only a modest number of investment opportunities, and securing them in today’s competitive environment is a challenge).  The Real Estate Debt Fund can only lever up to 1-to-1, and the other three borrow only small amounts and for short-term purposes, so none of them entails significant leverage risk.  However, in order to succeed they’ll all require a high level of skill from their managers in identifying return prospects and keeping risk under control. Thus they all entail manager risk. Our response is to entrust these portfolios only to managers who’ve been with us for years. It’s reasonable – essential, really – to study the risk entailed in every investment and accept the amounts and types of risk that you’re comfortable with (assuming this can be discerned). It’s not reasonable to expect highly superior returns without bearing some incremental risk.

And some investment strategies don’t permit full diversification because of the limitations of their subject markets. Thus problems – if and when they occur – will be bigger per se.  Especially given today’s low interest rates, borrowing additional capital to enhance returns is another way to potentially increase returns. But doing so introduces leverage risk. Leverage adds to risk two ways. The first is magnification: people are attracted to leverage because it will magnify gains, but under unfavorable outcomes it will magnify losses instead. The second way in which leverage adds to risk stems from funding risk, one of the classic reasons for financial disaster. The stage is set when someone borrows short-term funds to make a long-term investment. If the funds have to be repaid at an awkward time – due to their maturity, a margin call, or some other reason – and the purchased assets can’t be sold in a timely fashion (or can only be sold at a depressed price), an investment that might otherwise have been successful can be cut short and end in sorrow. Little or nothing may remain of the sale proceeds once the leverage has been repaid, in which case the investor’s equity will be decimated. This is commonly called a meltdown. It’s the primary reason for the saying, “Never forget the six-foot- © OAKTREE CAPITAL MANAGEMENT, L.P. ALL RIGHTS RESERVED.

© Oaktree Capital Management, L.P. All Rights Reserved tall man who drowned crossing the stream that was five feet deep on average.” In times of crisis, success over the long run can become irrelevant.  When credit risk, illiquidity risk, concentration risk and leverage risk are borne intelligently, it is in the hope that the investor’s skill will be sufficient to produce success. If so, the potential incremental returns that appear to be offered as risk compensation will turn into realized incremental returns (per the graphic at the top of page 8). That’s the only reason anyone would do these things. As the graphic at the bottom of page 8 illustrates, however, investing further out on the risk curve exposes one to a broader range of investment outcomes. In an efficient market, returns are tethered to the market average; in an inefficient market, they’re not. Inefficient markets offer the possibility that an investor will escape from the “gravitational pull” of the market’s average return, but that can be either for the better or for the worse. Superior investors – those with “alpha,” or the personal skill needed to achieve outsized returns for a given level of risk – have scope to perform well above the mean return, while inferior investors can come out far below. So hiring an investment manager introduces manager risk: the risk of picking the wrong one. It’s possible to pay management fees but get decisions that detract from results rather than add.

Some or all of the above risks are potentially entailed in our new credit strategies. Parsing them allows investors to choose among the strategies and accept the risks they’re more comfortable with. The process can be quite informative. Our oldest “new strategy” is Enhanced Income, where we use leverage to magnify the return from a portfolio of senior loans. We think senior loans have the lowest credit risk of anything Oaktree deals with, since they’re senior-most among their issuer’s debt and historically have produced very few credit losses. Further, they’re among our most liquid assets, meaning we face relatively little illiquidity risk, and being active in a broad public market permits us to diversify, reducing concentration risk. Given the relatively high degree of safety stemming from these loans’ seniority, returns aren’t overly dependent on the presence of alpha, meaning Enhanced Income entails less manager risk than some other strategies. But to have a chance at the healthy return we’re pursuing in Enhanced Income requires us to take some risk, and what we’re left with is leverage risk. The 3-to-1 leverage in Enhanced Income Fund II will magnify the negative impact of any credit losses (of course we hope there won’t be many).

The fact that an investment is susceptible to a serious negative development that will occur only infrequently – what I call “the improbable disaster” – can make it appear safer than it really is. Thus after several years of a benign environment, a risky investment can easily pass for safe. That’s why Warren Buffett famously said, “. . . you only find out who’s swimming naked when the tide goes out.” Assembling a portfolio that incorporates risk control as well as the potential for gains is a great accomplishment. But it’s a hidden accomplishment most of the time, since risk only turns into loss occasionally . . . when the tide goes out. The fourth is that risk is multi-faceted and hard to deal with. In this memo I’ve mentioned 24 different forms of risk: the risk of losing money, the risk of falling short, the risk of missing opportunities, FOMO risk, credit risk, illiquidity risk, concentration risk, leverage risk, funding risk, manager risk, over- diversification risk, risk associated with volatility, basis risk, model risk, black swan risk, career risk, headline risk, event risk, fundamental risk, valuation risk, correlation risk, interest rate risk, purchasing power risk, and upside risk. And I’m sure I’ve omitted some. Many times these risks are overlapping, contrasting and hard to manage simultaneously. For example:  Efforts to reduce the risk of losing money invariably increase the risk of missing out.

However, we’re not worried about a meltdown, since the current environment allows us to avoid funding risk; we can (a) borrow for a term that exceeds the duration of the underlying investments and (b) do so without the threat of margin calls related to price declines. Strategic Credit, Mezzanine Finance, European Private Debt and Real Estate Debt are the other four components of our “ten percent solution.”  All four entail some degree of credit risk, illiquidity risk (they all invest heavily or entirely in private debt) and concentration risk (as their market niches offer only a modest number of investment opportunities, and securing them in today’s competitive environment is a challenge).  The Real Estate Debt Fund can only lever up to 1-to-1, and the other three borrow only small amounts and for short-term purposes, so none of them entails significant leverage risk. © OAKTREE CAPITAL MANAGEMENT, L.P. ALL RIGHTS RESERVED.

In this memo I’ve mentioned 24 different forms of risk: the risk of losing money, the risk of falling short, the risk of missing opportunities, FOMO risk, credit risk, illiquidity risk, concentration risk, leverage risk, funding risk, manager risk, over- diversification risk, risk associated with volatility, basis risk, model risk, black swan risk, career risk, headline risk, event risk, fundamental risk, valuation risk, correlation risk, interest rate risk, purchasing power risk, and upside risk. And I’m sure I’ve omitted some. Many times these risks are overlapping, contrasting and hard to manage simultaneously. For example:  Efforts to reduce the risk of losing money invariably increase the risk of missing out.  Efforts to reduce fundamental risk by buying higher-quality assets often increase valuation risk, given that higher-quality assets often sell at elevated valuation metrics. At bottom, it’s the inability to arrive at a single formula that simultaneously minimizes all the risks that makes investing the fascinating and challenging pursuit it is. The fifth is that the task of managing risk shouldn’t be left to designated risk managers. I’m convinced outsiders to the fundamental investment process can’t know enough about the subject assets to make appropriate decisions regarding each one. All they can do is apply statistical models and norms.

Moreover, a portfolio within one of the credit strategies may not be diversified among a wide range of issuers, industries and countries, making the portfolio subject to more rapid changes in value than would be the case if the portfolio was more diversified. Many factors affect the demand and supply of securities and instruments targeted by the strategies discussed herein and their valuation. Interest rates and general economic activity may affect the value and number of investments made by such strategies. Such strategies discussed herein may target investments in companies whose capital structures may have significant leverage. Such investments are inherently more sensitive than others to declines in revenues and to increases in expenses and interest rates. In addition, such strategies may involve the use of leverage. While leverage presents opportunities for increasing total return, it may increase losses as well. Accordingly, any event that adversely affects the value of an investment would be magnified to the extent leverage is used. Such strategies may also involve securities or obligations of non-U.S. companies which may involve certain special risks. These factors may increase the likelihood of potential losses being incurred in connection with such investments.

Further, the development of derivatives, in particular, vastly increased the ease with which risk could be shouldered (often without a complete understanding) as well as the amount of risk that could be garnered per dollar of capital committed.  While not a novel development, there was an enormous upsurge in buyouts. These included the biggest deals ever; higher enterprise values as a multiple of cash flow; increased leverage ratios; and riskier, more cyclical target companies, such as semiconductor manufacturers.  There was widespread structural deterioration. Examples included covenant-lite loans carrying few or none of the protective terms prudent lenders look for, and PIK-toggle debt on which the obligors could elect to pay interest “in kind” with additional securities rather than cash.  Finally, there was simply a willingness to buy riskier securities. Examples here included large quantities of CCC-rated debt, as well as debt issued to finance dividend payments and stock buybacks. The last two increase a company’s leverage without adding any productive assets that can help service the new debt. Toward the end, my 2007 memo included the following paragraph: Today’s financial market conditions are easily summed up: There’s a global glut of liquidity, minimal interest in traditional investments, little apparent concern about risk, and skimpy prospective returns everywhere.

Thus, as the price for accessing returns that are potentially adequate (but lower than those promised in the past), investors are readily accepting significant risk in the form of heightened leverage, untested derivatives and weak deal structures. The current cycle isn’t unusual in its form, only its extent. There’s little mystery about the ultimate outcome, in my opinion, but at this point in the cycle it’s the optimists who look best. (emphasis in the original) © OAKTREE CAPITAL MANAGEMENT, L.P. ALL RIGHTS RESERVED.

© Oaktree Capital Management, L.P. All Rights Reserved.  Bad times cause the level of building activity to be low and the availability of capital for building to be constrained. Or, as we said in computer programming in the 1960s, “go to top” and begin again. This process is highly illustrative of the cyclical chain reaction I’m talking about. Each step in this progression doesn’t merely follow the one that preceded it; it is caused by the one that preceded it. Cycles and Risk This memo is devoted to the cycle in attitudes toward risk. Economies rise and fall quite moderately (think about it: a 5% drop in GDP is considered massive). Companies see their profits fluctuate considerably more, because of their operating and financial leverage. But market gyrations make the fluctuations in company profits look mild. Securities prices rise and fall much more than profits, introducing considerable investment risk. Why is that so? Primarily, I think, because of the dramatic ups and downs in investor psychology. The economic cycle is constrained in its fluctuations by the existence of long-term contracts and the fact that people will always eat, pay rent, buy gasoline, and engage in many other activities. The quantities involved will rise and fall, but not without limitation. Likewise for most companies: cost reductions can mitigate the impact of sales declines on earnings, and there’s often some base level below which sales are unlikely to go.

© Oaktree Capital Management, L.P. All Rights Reserved. Now we’re seeing another upswing in risky behavior. It began surprisingly soon after the crisis (see Warning Flags, May 2010), spurred on by central bank policies that depressed the return on safe investments. It has gathered steam ever since, but not to anywhere near the same degree as in 2006-07.  Wall Street has, thus far, been less creative in terms of financial engineering innovations. I can’t think of a single new “modern miracle” that’s been popularized since the crisis.  Likewise, derivatives are off the front page and seem to be created at a much slower pace. A full resumption of derivatives creation and other forms of financial innovation appears to be on hold pending clarification of the regulatory uncertainty surrounding acceptable activity for banks.  Buyout activity seems relatively subdued. In 2006-07, it seemed a buyout in the tens of billions was being announced every week; now they’re quite scarce. Many smaller deals are taking place, however, including a large number of “flips” from one buyout fund to another, and leverage ratios have moved back up toward the highs of the last cycle.  “Cov-lite” and PIK-toggle debt issuance is in full flower, as are triple-Cs, dividend recaps and stock buybacks.

It’s highly informative to assess how the other characteristics of 2007 enumerated above compare with conditions today:  global glut of liquidity – check  minimal interest in traditional investments – check (relatively little is expected today from Treasurys, high grade bonds or equities, encouraging investors to shift toward alternatives)  little apparent concern about risk – check  skimpy prospective returns everywhere – check Risk tolerance and leverage haven’t returned to their pre-crisis highs in quantitative terms, but there’s no doubt in my mind that risk bearing is back in vogue. Examples from the Media My preparation for writing these memos often includes amassing media citations around a central theme. Here are some from the last few weeks:  Now, eight years since the PIK-toggle entered the market, companies are again using the esoteric structures, along with a host of riskier borrowing practices associated with the buyout boom that helped inflate the 2006-07 credit bubble. (Financial Times, October 22)  At the same time, more than $200bn of “cov-lite” loans have been sold so far this year, eclipsing the $100bn issued in 2007. That means 56 per cent of new leveraged loans now come with fewer protections for lenders than normal loans. (Ibid.)  Bankers say much of that issuance has been a result of the return of another pre-crisis market vehicle – the collateralised [sic] loan obligation. . . . Like the rest of the leveraged © OAKTREE CAPITAL MANAGEMENT, L.P.

© Oaktree Capital Management, L.P. All Rights Reserved. loan market, CLOs have enjoyed buoyant demand. At least $55.41bn of the vehicles have been sold this year – the highest amount since the $88.94bn issued in 2007. (Ibid.)  Bonds rated CCC or lower -- at least eight steps below investment grade -- by S&P have gained 11 percent this year, compared with about a 6 percent gain for all dollar- denominated junk bonds or a loss of more than 1 percent for investment-grade debt, according to Bank of America Merrill Lynch index data. (Bloomberg, November 19)  . . . the amount of indebtedness in leveraged buyout deals is creeping up. The average amount of debt used to finance LBOs has jumped from a low of 3.69 times earnings in 2009 to an average of 5.37 so far this year, according to data from S&P Capital IQ. At the height of the LBO boom, average leverage was 6.05. (Financial Times, October 22)  Subprime loans, given to people with little proven ability to pay, are making a comeback, this time to buy cars. Issuance of bonds linked to loans for the shakiest borrowers hit $17.2 billion this year, more than double the amount sold during the same period in 2010, according to Harris Trifon, a debt analyst at Deutsche Bank AG. (Bloomberg, November 19)  A Goldman Sachs index of [the stocks of] companies with weaker balance sheets has rallied 42 percent this year, almost doubling the gain in a measure of more creditworthy firms. (Ibid.)

© Oaktree Capital Management, L.P. All Rights Reserved. But was it desirable? It was not, in my view, because hindsight shows perception to have been very much out of proportion with reality, and thus dangerous:  Consumer confidence, and thus spending, was too high relative to incomes.  Excessive spending – all around the world, at all economic levels – led to excessive use of credit, making the world highly overleveraged.  Buying fueled by confidence and leverage caused asset prices to rise out of proportion to value. I often say the riskiest thing in the world is widespread belief that there’s no risk. And certainly that was the prevailing condition in the pre-crisis years of 2005-07, as well as during the tech bubble of the late 1990s. In both instances the “era of well-being” was followed by a significant economic slowdown and market decline. A feel-good environment characterized by strong confidence creates pleasant current conditions but encourages dangerous behavior and an ascent (in the economy and the markets) from which a correction becomes inevitable. In that way, the less confident attitudes of 2013 create a lackluster, less enjoyable environment, but also a preferable and more prudent base for the future.

Investors feel richer and smarter, forget their prior bad experience, and extrapolate the recent progress.  Skepticism and caution abate; optimism and aggressiveness take their place.  Anyone who’s been sitting out the dance experiences the pain of watching from the sidelines as assets appreciate. The bystanders feel regret and are gradually sucked in.  The longer this process goes on, the more enthusiasm for investments rises and resistance subsides. People worry less about losing money and more about missing opportunities.  Risk aversion evaporates and investors behave more aggressively. People begin to have difficulty imagining how losses could ever occur.  Financial institutions, subject to the same influences, become willing to provide increased financing. In the words of Citibank’s Chuck Prince, when the music’s playing, they see no choice but to dance. Thus they compete for market share by reducing the return they demand and by being willing to finance riskier deals (see The Race to the Bottom, February 14, 2007).  Easier financing – along with the recent gains – encourages investors to make greater use of leverage. Borrowed capital increases their buying power, and they move to put it to work.  Leveraged investors report the greatest gains, consistent with the old Las Vegas maxim: “the more you bet, the more you win when you win.” This causes others to emulate them.  The market takes on the appearance of a perpetual-motion machine.

Appreciation accelerates, possibly leading to a mania or bubble. Everyone concludes that things can only get better forever. They forget about the risk of losing money and fixate on not missing opportunities. Leveraged buyers become convinced that the things they buy with borrowed money are certain to appreciate at a rate above their borrowing cost.  Eventually things get as good as they can get, the last skeptic capitulates, and the last potential buyer buys. That’s the way the cycle of attitudes toward risk ascends. The skeptic in times of moderation becomes a true believer at the top. © OAKTREE CAPITAL MANAGEMENT, L.P. ALL RIGHTS RESERVED.

© Oaktree Capital Management, L.P. All Rights Reserved. when it was published on July 16, I changed the title to “It’s All Good.” In the memo I complained that every asset class, every asset and every region was appreciating. In terms of amplitude, breadth and potential ramifications, I consider it the strongest, most heated upswing I’ve witnessed. A lot of this is because people seem to think everything’s good and likely to stay that way. As I saw it, overconfident investors were ignoring the possibility of things going down as well as up, swallowing promises of limitless potential, suspending disbelief, accepting financial innovation as sure to work, and embracing the trend toward increased leverage. Of course, this house of cards fell apart in short order. Thus that memo was followed by “It’s All Good . . . Really?” two weeks later, on July 30, and then by “Now It’s All Bad?” on September 10. In just eight weeks, confidence had evaporated and been replaced by widespread pessimism. And just a year after that, we witnessed the bankruptcy of Lehman Brothers and the onset of the worst financial crisis in 80 years. What this reminds us is how dangerous the world can be when confidence is too high and people are too comfortable. Also, the speed with which things can reverse demonstrates, as my partner Sheldon Stone says, that the air goes out of the balloon much faster than it goes in.

The result is a more dangerous world where asset prices are higher, prospective returns are lower, risk is elevated, the quality and safety of new issues deteriorates, and the premium for bearing risk is insufficient. It’s one of my first principles that we never know where we’re going – given the unreliability of macro forecasting – but we ought to know where we are. “Where we are” means what the temperature of the market is: Are investors risk-averse or risk-tolerant? Are they behaving cautiously or aggressively? And thus is the market a safe place or a risky one? Certainly risk tolerance has been increasing of late; high returns on risky assets have encouraged more of the same; and the markets are becoming more heated. The bottom line varies from sector to sector, but I have no doubt that markets are riskier than at any other time since the depths of the crisis in late 2008 (for credit) or early 2009 (for equities), and they are becoming more so. Is This a Sell Signal? If Not, Then What? No, I don’t think it’s time to bail out of the markets. Prices and valuation parameters are higher than they were a few years ago, and riskier behavior is observed. But what matters is the degree, and I don’t think it has reached the danger zone yet. First, as mentioned above, the absolute quantum of risk doesn’t seem as high as in 2006-07. The modern miracles of finance aren’t seen as often (or touted as highly), and the use of leverage isn’t as high.

has borrowed heavily to live beyond its means; we have been consuming through easy credit what we otherwise would have had to wait to buy. In the words of Michael Lewis, “Leverage buys you a glimpse of a prosperity you © OAKTREE CAPITAL MANAGEMENT, L.P. ALL RIGHTS RESERVED.

© Oaktree Capital Management, L.P. All Rights Reserved. haven’t really earned.” Asset values are contingent, as Jim Grant once said. But debt is forever. Instead of cutting back on leverage and getting our house in order, government response to the crisis has been to shift unaffordable debt from individual balance sheets onto the national ledger, where every day we owe more than ever before. . . . I believe it is possible that the average citizen understands our country’s fiscal situation better than many of our politicians or prominent economists. Most people seem to viscerally recognize that the absence of an immediate crisis does not mean we will not eventually face one. They are wary of believing promises by those who failed to predict previous crises in housing and in highly leveraged financial institutions. They regard with skepticism those who don’t accept that we have a debt problem, or insist that inflation will remain under control. (Indeed, they know inflation is not well under control, for they know how far the purchasing power of a dollar has dropped when they go to the supermarket or service station.) They are pretty sure they are not getting reasonable value from the taxes they pay. When an economist tells them that growing the nation’s debt over the past 12 years from $6 trillion to $16 trillion is not a problem, and that doubling it again will still not be a problem, this simply does not compute.

© Oaktree Capital Management, L.P. All Rights Reserved. I find it remarkable that the average high yield bond offers only about 6% today. Daily I see my partner Sheldon Stone selling callable bonds at prices of 110 and 115 because their yields to call or yields to worst start with numbers – “handles” – of 3 or 4 percent. The yields are down to those levels because of strong demand for short paper with prospective returns in that range. I’ve never seen anything like it.  As was the case in the years leading up to the onset of the crisis, the ability to execute aggressive transactions indicates the presence of risk tolerance in the markets. Triple-C bonds can be issued readily. Companies can borrow money for the purpose of paying dividends to their shareholders. And CLOs are again being formed to buy leveraged loans with heavy leverage.  The amount of leverage being applied in today’s private equity deals also indicates a return to risk taking. As The Wall Street Journal reported on December 17: Since the beginning of 2008, private-equity firms have paid an average of 42% of the cost of large buyouts with their own money, also known as “equity,” while borrowing the rest. In the past six months, the percentage has fallen to 33%, according to Thomson Reuters, close to the 31% average in 2006 and the 30% average in 2007. . . . Other measures also suggest that debt loads are hovering around pre-crisis levels.

The average debt put on companies acquired in leveraged-buyout deals from July to December amounted to 5.5 times the companies’ annual earnings (defined as earnings before interest, taxes, depreciation and amortization). That is higher than any two consecutive quarters since the beginning of 2008, according to S&P Capital IQ LCD. The average deal leverage was 5.4 times earnings in 2006 and 6.2 times earnings in 2007. The good news is that today’s investors are painfully aware of the many uncertainties. The bad news is that, regardless, they’re being forced by the low interest rates to bear substantial risk at returns that have been bid down. Their scramble for return has brought elements of pre-crisis behavior very much back to life. Please note that my comments are directed more at fixed income securities than equities. Fixed income is the subject of investors’ ardor today, since it’s there that investors are looking for the income they need. Equities are still being disrespected, and equity allocations reduced. Thus they are not being lifted by comparable income-driven buying. * * * In 2004, as cited above, I stated the following conclusion: “There are times for aggressiveness. I think this is a time for caution.” Here as 2013 begins, I have only one word to add: ditto. © OAKTREE CAPITAL MANAGEMENT, L.P. ALL RIGHTS RESERVED.

CONFIDENTIAL © Oaktree Capital Management, L.P. All Rights Reserved. And what does the fact that we can’t know these things mean for our portfolio management? Simple: it means we mustn’t act as if we can. If you could know these things, the path to success would be clear: Stick to markets that will do well and avoid the rest. Concentrate on the individual securities that will be the best performers. Load up when the market’s about to rise and get out at the top. And use maximum leverage when the return will exceed the cost of capital and none when it won’t. But what if you can’t? You should acknowledge your limitations, enroll in the “I don’t know” school of thought, and accommodate your behavior to reality (see “Us and Them,” May 7, 2004). The more you acknowledge you don’t know what the future holds:  the more you should diversify, spreading your bets to make sure you don’t miss the winners or, more importantly, overload on the losers,  the less you should attempt to augment performance through adroit short-term market timing, and  the less you should employ leverage. The difference in behavior between those who think they can know the future and those who don’t is potentially enormous. It’s essential to be on the right side of this choice because, as Mark Twain said, “It ain’t what you don’t know that gets you into trouble. It’s what you know for sure that just ain’t so.” That’s an essential component of the formula for investment survival. What Can We Do?

CONFIDENTIAL © Oaktree Capital Management, L.P. All Rights Reserved. But as Twain also said, there are themes that rhyme. It‟s what I would call “tendencies” or “behavioral patterns” that present the important lessons. The tendency of investors to overlook or forget the past is noteworthy. So is their habit of succumbing to emotion and swallowing tall (but potentially lucrative) tales. In particular, people tend to forget the cyclical nature of things, extrapolate past trends to excess, and ignore the likelihood of regression to the mean. The tech bubble may not recur anytime soon. No online grocer may ever again sell at 200 times revenues. There may never be another CDO-squared or SIV. Those aren‟t the things that matter. But there’s sure to be another cycle, another bubble and another crisis. There’ll be another time when people overpay for exciting investment ideas because their future appears limitless, and then a time of disillusionment and price collapse. There’ll be another period when leverage is embraced to excess, and then, consequently, a period when it gets people killed. And there’ll certainly be another time when people can only imagine the possibility of gain, and then one when – after huge sums have been lost – they can think only of further declines. These are the kinds of things that rhyme. If we stay alert, we can anticipate and recognize them and thus avoid the losses and opportunity costs they bring so reliably.

© Oaktree Capital Management, L.P. All Rights Reserved. Economic growth doesn’t just happen. Its vigor depends on a combination of population gains, a conducive infrastructure, positive aspiration and profit motive, advances in technology and productivity, and benign exogenous developments. In many ways and to varying degrees, I think the future for these things in the U.S. is less good than it was in the past. The birthrate is down; our infrastructure is out of date; it’s uncertain whether technology can add as much to productivity in the future as it has in the recent past (but perhaps it always is); and mobility up the income curve has stagnated. I think a lot about the role of deficit spending and credit. In the forty or so years leading up to the crisis of 2008, consumers could grow their spending faster than their incomes because of the increasing availability of credit (and their increasing willingness to make use of it). Likewise, generous capital markets greatly facilitated deficit spending on the part of governments. Economic units around the world were able to spend money they didn’t have and thus buy things they couldn’t afford. This made a big contribution to economic growth, but few people recognized the negative implications: increased leverage, increased dependency on the continued generosity of the capital markets, and thus increased precariousness. In other words, unwise behavior in the short run led directly to problems in the long run.

 We can control our egos and emotions. The biggest errors are made when the investing herd is driven by emotion: to buy at the top by greed and excitement, and to sell at the bottom by fear and despondency. These errors are compounded when investors – even professionals – surrender to their egos and overestimate the degree to which their judgments are correct. Superior managers can help their clients by refusing to mirror these flaws.  We can act as contrarians. Given the way the emotion-led consensus is wrong at the extremes as described above, there’s money to be made by doing the opposite. Objectivity, insight and ego control are all you need. But it’s far from easy. The successful contrarian has to have a sense for what the herd is doing, understand what’s wrong with its behavior, resist the emotions driving it and do the opposite – all of this despite being “only human” and thus not immune to the forces driving others.  We can behave counter-cyclically. The cycles in economies and markets conspire to cause investment mistakes. For example, in advanced up-cycles: o the economic indicators show gains, o companies report earnings increases, o assets appreciate, o investors enjoy good returns, o riskier approaches outperform, o leverage adds to gains, and o the capital markets eagerly provide financing. © OAKTREE CAPITAL MANAGEMENT, L.P. ALL RIGHTS RESERVED.

Working with CIOs Landis Zimmerman (now at Howard Hughes Medical Institute) in the early years and especially closely with Kristin Gilbertson in 2004-2010, the Investment Board and I led gradual diversification into growth stocks, emerging markets and defense-oriented hedge funds, with an emphasis on managers stressing risk-control. We established an allocation for private equity but implemented it very slowly. We kept an above-average percentage of the portfolio in publicly traded securities. And, importantly, we maintained a substantial allocation to cash and U.S. Treasurys, solely to enable us to meet the need for cash for operations and thereby avoid having to sell assets in a time of depressed prices. The Results The performance produced by these decisions was quite predictable. With its low-risk portfolio, Penn outperformed when risk taking was penalized but trailed when risk taking was rewarded. It outperformed when value stocks did well but lagged when more aggressive tools, including leverage and portable alpha, paid off. For the decade overall it lagged the average of its peer institutions by a small margin and exhibited lower volatility. No surprise there. Penn’s return was about 5½% for FY2001-10, while most of its peers made 6% or 7%. But average results don’t tell the whole story. It’s important to remember one of my favorite adages, about the six-foot-tall man who drowned crossing the stream that was five feet deep on average.

© OAKTREE CAPITAL MANAGEMENT, L.P. ALL RIGHTS RESERVED. CONFIDENTIAL © Oaktree Capital Management, L.P. All Rights Reserved. The foregoing goes a long way to support Yogi Berra’s observation that “In theory there is no difference between theory and practice. In practice there is.” Theory has no answer for the impact of these forces. Theory assumes investors are clinical, unemotional and objective, and always willing to substitute a cheap asset for a dear one. In practice, there are numerous reasons why one asset can be priced wrong – in the absolute or relative to others – and stay that way for months or years. Those are mistakes, and superior investment records belong to investors who take advantage of them consistently. A Case In Point Bruce Karsh and his distressed debt team have averaged returns of roughly 23% per year before fees and 18% after fees for more than 23 years without any use of borrowed capital. All eighteen of their funds have been profitable, and money-losing years have been quite scarce. I consider this record nothing short of aberrant. You’re simply not supposed to be able to make that kind of return for that long, and especially without the use of leverage. Investing skill aside, what made it possible?  Is it because it’s called “distressed debt”? That can’t be it; there’s nothing in a name.  Is it because distressed debt is an undiscovered market niche?

© Oaktree Capital Management, L.P. All Rights Reserved. o what will be done, and o what the ramifications will be, especially the second-order consequences. I imagine Europe’s leaders will muddle through, continuing to do the absolute minimum that suffices at the last possible moment. There will be palliatives, but solutions will be hard to achieve (the latter would require the nations of Europe to significantly surrender sovereignty). Last week the European Central Bank announced a program of bond buying, and this was viewed positively. Buying bonds will keep borrowing costs down for as long as it’s practiced, but it won’t solve the problems. The important tasks facing the peripheral nations are much greater: cutting deficits and policing them, reducing the excessive debt burden that was allowed to build up, and restoring growth and competitiveness. Thus the problem is likely to drag on for years, assuming it doesn’t flare up into a global crisis. Everyone hopes Europe will do what’s needed, but hope isn’t much of a plan.  The U.S. fiscal situation is less acute, less immediate, and easier to duck given that we can print the world’s reserve currency . . . but little better. In fact, in some ways it is more dangerous because the problems are more back-end loaded and perhaps less overt. Our politicians, too, used easy money to give everyone everything: generous benefit programs as well as significant tax reductions (and major stimulus programs when needed).

This combination drove large-scale investment into either properties or savings products known as “trusts,” the proceeds of which flowed into fixed asset development. Thus the process went out of control. Good intentions around urbanization and infrastructure development fell victim to massive speculative capital flows. The consequence was excessive fixed investment. (One great way for authorities or central bankers to stimulate an economy is by providing capital for residential construction. This results in increased employment and spending on materials and components. When the economy heats up in response, however, a housing bubble often ensues. Home prices rise and speculative buying follows. The only thing missing is end-buyers for the unneeded or unaffordable homes. It’s particularly interesting to note that excess residential investment contributed in a major way to the recent problems in China, Ireland, Spain and the U.S. In all four countries “Potemkin villages” of new homes grew up, suggesting economic vigor . . . but standing empty.) In China’s case, capital wasn’t withdrawn by external lenders. Rather, the central planners decided it was time to reduce stimulus. In this way leverage would be reduced, the rate of fixed asset investment would ease, and the economy would be kept from overheating and inflating. However, as has been seen throughout history, planned economies tend to defy the planners, and cycles are hard to modulate.

© Oaktree Capital Management, L.P. All Rights Reserved. On one hand, we face a lackluster general economic outlook and the threat of further negative developments that could be impactful but hopefully are not overwhelmingly likely. On the other, these worries may be offset to a degree by the lowness of asset prices and investor psychology. The former elements argue strongly against aggressive investing, but the latter – and the low promised returns on highly safe investments – argue that one’s investment program should include some forward movement. When I attended the University of Chicago it was very fashionable to use the qualifier ceteris paribus: “all other things being equal.” So I can flatly state that, ceteris paribus, an outlook characterized by slow growth, potential serious problems and great uncertainty should call for (a) more fixed income investments than equities, (b) more pursuit of value today than growth tomorrow and (c) more safe investments and less use of leverage. However – and it’s the biggest possible “however” – all else is far from equal today. Safe investments have been bid up, such that the returns available on them are paltry at best. If you buy the ten-year U.S. Treasury note today at 1.7%, it’s hard to imagine environments other than depression and deflation in which you’ll be happy with the outcome. So one of the more important conclusions is that this isn’t a black-and-white world in which it’s reasonable to insist on safety and eschew risk.

Market crises are chaotic, not orderly, and the multiplicity and simultaneity of contributing causes play a big part in making them so. That was certainly the case in the three crises we’ve lived through as investors in credit. In addition to the recession and credit crunch that marked each one, we saw:  in 1990, the collapse of the most prominent leveraged buyouts of the 1980s; the Gulf War, with Iraq’s invasion of Kuwait and the allies’ response; and the government’s crusade against high yield bonds, Drexel Burnham and Michael Milken;  in 2002, the aftermath of 9/11, including our invasion of Afghanistan; the unraveling of the overbuilt fiber telecom industry; and the exposure of accounting scandals at Enron, WorldCom and Adelphia and the fall of Arthur Andersen; and  in 2008, the sub-prime mortgage meltdown; the defrocking of tranching, leverage and derivatives as constructive forces; the outing of credit rating agencies as no more © OAKTREE CAPITAL MANAGEMENT, L.P. ALL RIGHTS RESERVED.

We saw a similar turn in Britain under the leadership of Margaret Thatcher; the collapse of the USSR and a resounding victory for capitalism; and the ascendance of free market adherents Alan Greenspan and George W. Bush. With the economy and financial system generating prosperity, people wanted more of the same. And with manufacturing in decline, we relied heavily on the financial sector for an increased contribution to GDP, job creation and standards of living. The prevailing view was that the less regulation we had, the more productive business and finance could be. And what was there to be feared from an unregulated economy, anyway? The result in the past decade, according to a great newspaper quote that sadly I can’t locate, was “the kind of regulation you get from an administration that doesn’t believe in regulation.” Thus, coming full circle from the 1930s, starting in 1999 we saw revocation of Glass-Steagall; elimination of the up-tick rule limiting short sales to instances when stock prices were rising; a pivotal decision to exempt derivatives from regulation; increased permitted leverage at investment banks; and starvation of regulatory agency budgets. These developments were followed by the global financial crisis of 2007-08. Coincidence or causality? Free Markets Are Dangerous – Regulation is Essential The free-market, capitalist system runs on self interest and the desire for profit. We need regulation to ensure those things are kept within reasonable limits.

” In other words, there’s a powerful tendency to believe that which could make one rich if it were true. I’ve tried to spend the last 42 years with my eyes open and my memory engaged. As a result, a lot of what I write is based on recognition of past patterns. It’s time to put my recollections to work, because I’m definitely seeing a trend in the direction of Galbraith’s “same or closely similar circumstances.” The Not-So-Distant Past It seems it was impossible – unless you were John Paulson – to escape entirely unscathed from the financial crisis of 2007-08. Most investors could only hope to have turned cautious in the run-up to the crisis, sold assets, increased the defensiveness of their remaining holdings, reduced or eschewed leverage, and secured capital with which to buy at the bottom in order to benefit from the subsequent recovery. What might have prompted investors to do these things in advance of the mid-2007 onset of the crisis? Almost no one fully foresaw the impending subprime meltdown, and few macro-forecasts and market analyses were sufficiently pessimistic. Rather, I think investors would have been most likely to take the appropriate actions if they were aware of the pro-risk behavior taking place around them. © Oaktree Capital Management, L.P.Reserved

They believed that the markets had been rendered safe by the combination of (a) an omniscient, omnipotent Fed providing a “Greenspan put,” (b) the wonders of securitization, tranching and selling onward and (c) the “wall of liquidity” coming toward our markets, composed of excess reserves being recycled by China and the oil-producing nations. They accepted the alchemy under which financial engineering could turn sub- prime mortgages into triple-A debt. And they viewed leverage as sure to have a salutary effect on returns. There’s nothing more risky than a widespread belief that there’s no risk . . . but that’s what characterized the investment world. It was possible to conclude in 2005- 07 that investors were applying insufficient risk aversion and thus engaging in risky behavior, elevating asset prices, reducing prospective returns, and raising risk levels. What were the signs?  The issuance of non-investment grade debt was at record levels.  An unusually high percentage of the issuance was rated triple-C, something that’s not possible when attitudes toward risk are sober.  “Dividend recaps” went unquestioned, with buyout companies borrowing money with which to pay dividends, vastly increasing their leverage and reducing their ability to get through tough times.

CONFIDENTIAL © Oaktree Capital Management, L.P. All Rights Reserved low base. The rate of activity is now roughly similar to the average level of activity since 1985, excluding the boom and bust period of 2006 to 2009. . . . today’s deals are similar in size but the number of deals has risen by more than the dollar value of deals. We also see that the leverage in the deals is increasing. For example, so far this year the average deal was financed with 30% equity, down from last year’s 38%, though still up from the most leveraged period of 2005 to 2009 when deals were financed with an average of 25% equity. The leveraged loan market has also picked up and an increasing percentage of leveraged loans are going toward LBOs. A few new CLOs and mutual funds have been created that are concentrated on the leveraged loan market, indicative of renewed demand. Investor demand has pushed prices back up to par and allowed a decline in the average credit quality of the loans, with increasing indications of “covenant light” loans getting done. In other words, in most regards the capital markets – and investors’ tolerance of risk – are retracing their steps back in the direction of the bubble-ish pre-crisis years. Low yields, declining yield spreads, rising leverage ratios, payment-in-kind bonds, covenant-lite debt, increasing levels of LBO activity and the beginnings of the return of levered, structured vehicles . . . all of these are available for the eye to see.

CONFIDENTIAL © Oaktree Capital Management, L.P. All Rights Reserved. made for a strong rebound. In particular, job growth was slow and unemployment remained at stubbornly high levels. But then, concurrent with the explosion of uncertainty over debt in the U.S. and Europe, slower growth was reported for the second quarter and the gains of the first quarter and late 2010 were revised downward. All of a sudden, another contributor to the sense that “it’s all good” had turned negative instead. I always hasten to point out that I am not an economist (and Oaktree doesn’t have one). Thus I don’t have a strong opinion as to whether the U.S. will relapse into a double dip. (I also have no idea how people reach firm conclusions on such things, other than as expressions of their biases and hunches.) For our purposes, it suffices that we have operated since the financial crisis under the assumption that the recovery would be sluggish, rather than V-shaped. We still feel that way. And that feeling is inconsistent with moving out on the risk curve or down in credit quality, investing more in cyclicals or taking on leverage.

CONFIDENTIAL © Oaktree Capital Management, L.P. All Rights Reserved volunteers” – people who do things because they have no choice. They’re also not oblivious to the risks that exist. I imagine the typical investor as saying, “I’m not happy, but I have to buy it.” Finally, the leverage used at the peak of risk-prone pursuit of return in 2005-07 isn’t nearly as prevalent today, perhaps because investors are chastened, but more likely because it’s not available in the same amounts. There may be corners of the market where elevated popularity and enthusiastic buying have caused prices to move beyond reason: high-tech stocks, social networks, emerging markets from time to time, perhaps gold and other commodities (what’s the reasonable price for a non-cash-flow-producing asset?) But for the most part, I think investors are taking the least risk they can while assembling portfolios that they think can achieve their needed returns or actuarial assumptions. In general, I would describe most security prices as falling somewhere between fair and full. Not necessarily bubbly, but also not cheap. Especially since the publication of my book, people have been asking me for the secret to risk control. “Okay, I’ll read the 180 pages. But what’s really the most important thing?” If I had to identify a single key to consistently successful investing, I’d say it’s “cheapness.

it goes. If it works well this time, readers may conclude that in the future they can fashion their own memos from bits and pieces of my old ones. The Credit Cycle at Work Consider this: the ups and downs of economies are usually blamed for fluctuations in corporate profits, and fluctuations in profits for the rise and fall of securities markets. However, in recessions and recoveries, economic growth usually deviates from its trendline rate by only a few percentage points. Why, then, do corporate profits increase and decrease so much more? The answer lies in things like financial leverage and operating leverage, which magnify the impact on profits of rising and falling revenues. And if profits fluctuate this way – more than GDP, but still relatively moderately – why is it that securities markets soar and collapse so dramatically? I attribute this to fluctuations in psychology and, in particular, to the profound influence of psychology on the availability of capital. In short, whereas economies fluctuate a little and profits a fair bit, the credit window opens wide and then slams shut . . . thus the title of this memo. I believe the credit cycle is the most volatile of the cycles and has the greatest impact. Thus it deserves a great deal of attention. In “The Happy Medium,” I discussed the workings of the credit cycle in creating market extremes: Looking for the cause of a market extreme usually requires rewinding the videotape of the credit cycle a few months or years.

In the low- return climate of the time, much of the appeal of these asset classes came from the fact that they promised higher returns thanks to their use of leverage, whether through borrowing, tranching or derivatives. Given the high promised returns, investors forgot about (or chose to ignore) the ability of leverage to magnify losses as well as gains. Contributing to investors’ rosy view of leverage’s likely impact was their belief that risk had been banished by (a) the efficacy of the Fed and its “Greenspan put,” (b) the combination of securitization, disintermediation, tranching, decoupling and financial engineering, and (c) the “wall of liquidity” coming toward us from China and the oil producing nations. For these reasons, few market participants were afraid of losing money. Most just worried about missing opportunity. The unattractive outlook for stocks and bonds meant investors would have to be aggressive and innovative if they were going to earn significant returns in the low-return environment. Thus risk aversion (a) was unnecessary and (b) would be counter-productive. “You’d better invest in this new financial product,” people were told. “If you don’t, you’ll miss out. And if you don’t and your competitor does – and it works – you’ll look out-of-step and fall behind.” When contemplating a virtuous circle without end, investors usually think of only one word: “buy.

powder” and intestinal fortitude with which to buy. That’s the background. Where do we stand today? Signs of the Times Optimism, adventurousness and unworried behavior characterized the pre-crisis period, and investor behavior reflected those attitudes. In my memo “It’s All Good” (July 16, 2007), just before the onset of the crisis, I mentioned some of the warning signs in the credit markets: Unlike the historic norm, it’s routine today to issue CCC-rated bonds. It’s easy to borrow money for the express purpose of distributing cash to equity holders, magnifying the company’s leverage. It’s so easy to issue bonds with little or no creditor protection in the indenture that a label has been coined for them: “covenant-lite.” And it’s possible to issue bonds whose interest payments can be paid in more bonds at the option of the borrower. The first requirement for an elevated opportunity in distressed debt is the unwise extension of credit, which I define as the making of loans which borrowers will be unable to service if things get a little worse. This happens when lenders fail to require a sufficient margin of safety. . . . The default rate in the high yield bond universe is at a 25-year low on a rolling-twelve-month basis. Under such circumstances, how could the average supplier of capital be expected to maintain a high level of risk aversion and prudence, especially when doing so means ceding all the loan making to others?

While there are credit ratings and covenants to look at, it can take effort and inference to understand the significance of these things. In feeding frenzies caused by excess availability of funds, recognizing and resisting this trend seems to be beyond the majority of market participants. This is one of the many reasons why the aftermath of an overly generous capital market includes losses, economic contraction and a subsequent unwillingness to lend. The bottom line of all of the above is that generous credit markets usually are associated with elevated asset prices and subsequent losses, while credit crunches produce bargain-basement prices and great profit opportunities. The Events of the Past Decade The last several years have provided a typical example of the credit cycle at work – typical in its pattern, that is, but unique in its extent and impact. The highs in risk tolerance, credulity, financial innovation and leverage seen between 2004 and early 2007 gave rise to a credit crunch in late 2007 and 2008 – the © Oaktree Capital Management, L.P.Reserved

greatest of our lifetimes – and to vast capital destruction. Structured and levered investment vehicles melted down, bringing unprecedented losses to those who had provided their capital, and forcing the sale of holdings regardless of price. Financial institutions flirted with potential insolvency, requiring their capital to be rebuilt via government programs. Money market funds and commercial paper had to be buoyed as well. Lehman Brothers went under. General Motors and Chrysler went bankrupt and required bailouts, and companies such as Fannie Mae, Freddie Mac, Merrill Lynch and Bear Stearns had to be supported or absorbed. All of this stemmed in large part from the too-easy availability of capital and from market participants’ irresponsible behavior in the middle of the decade. The result was a massive flight to quality and widespread refusal to take risk. In 2009, miraculously in my opinion, the responses of governments caused investor psychology to turn positive, and the pursuit of return caused risk tolerance to be restored. Risk capital became available again, enabling financial institutions to raise equity capital and highly indebted companies to access the capital markets, extending maturities and capturing the discounts on their debt. As a result – thanks to the rise in risk appetites – many markets showed their greatest gains ever.

So third, Treasury bill rates near zero – and note yields of 1 or 2 percent (depending on which country we’re talking about) – have the effect of driving investors toward riskier investments. Especially when fear and risk aversion recede, returns like these on Treasurys become unacceptable. Thus some money that otherwise would have been invested in the safe part of the fixed income market is forced to more aggressive places. Whatever fundamental doubt – and resulting reticence – might exist is in part offset by the unacceptably low returns on the safest of investments. Thus, for example, people who wouldn’t buy high yield bonds in the past at their traditional 12% yields, or at 20% in 2008, will buy them today at 7% primarily because they can’t stomach Treasurys at 2%. In the same way, alternative investment categories that fared poorly in the crisis can attract equity capital again (albeit in smaller amounts and to be paired with less leverage). The fourth impact is that interest rate declines cause asset appreciation. This restores wealth – household and otherwise – and with it the bullish feelings that give rise to increased willingness to spend money and bear risk. Fifth, quantitative easing (QE) puts cash in investors’ hands in exchange for the securities the Fed buys. This, too, should add to investors’ appetite for investing. © Oaktree Capital Management, L.P.Reserved

The Wall Street Journal of November 24, 2008 carried the following quotation from Irving Fisher, writing 76 years ago (“The Debt-Deflation Theory of Great Depressions,” Econometrica, March 1933): When it comes to booms gone bust, “over-investment and over-speculation are often important; but they would have far less serious results were they not conducted with borrowed money.” While this statement wasn’t made with regard to Greece or even to government activities in general, it is clearly relevant to the current situation. In recent years, most of the nations of the world spent more than they took in to give their citizens more of what they wanted. As long as the capital markets were open, few could think of a reason why this policy wouldn’t work forever. Economic units all over the globe were able to borrow to cover deficits. All that mattered was the ability to service the debt, even if that required borrowing money to pay interest. No one seemed to demand the ability to repay. When I was younger – in what seems like a distant past – national debt began to expand, and I remember heated debate regarding the significance, wisdom and likely consequences of that trend. The subject receded in recent years, since every nation now does it to some extent and people became inured to the controversy, as they tend to do. Two sentences stand out on this subject, from Bill Julian of Bill Julian Research on April 11.

Including loans, companies have raised $10.8 billion in debt to fund payouts this year, compared with $1 billion in all of 2009 and $1.3 billion in the prior 12 months, according to Standard & Poor’s LCD. Private-equity firms are taking advantage of record high-yield, high-risk bond sales and a rally in loans to extract cash from companies they own, awaiting a rebound in leveraged buyouts and initial public offerings. So- called dividend deals, which permeated debt markets in 2006 and 2007 before the credit seizure, may signal investors are becoming too complacent, said William Quinn, chairman of American Beacon Advisors Inc. “You start to be concerned that you’re increasing leverage, which was one of the things that created these problems in 2008,” said Quinn, who helps oversee $45 billion for the fund manager in Fort Worth, Texas. “I understand why private-equity firms do it, but I would be concerned.” (“Dividend Deals Rebound as Blackstone Seeks Cash,” Bloomberg, April 16) Companies may increase borrowing to pay shareholder dividends in a record year for junk bonds, Standard & Poor’s said. . . . “We are starting to see the proceeds of high-yield issues being channeled to shareholders as dividends, something that is less- welcome from a credit perspective, reminiscent of the leveraged finance market back in 2007,” analysts led by Taron Wade wrote . . . . Companies owned by LBO firms in 2007 issued a record 6.

I went on to urge caution when investing in such a low-return environment. It was early, but it turned out to have been in order. There are differences today. Yield spreads on non-investment grade debt are above average. Leverage is only available in more moderate amounts. With investors chastened by cash squeezes in 2008, the flow of capital to private strategies is limited. Equity p/e ratios are below the historic average. And investors seem to be conscious of the economic and geopolitical uncertainties. But there are also direct similarities, primarily in the fact that inadequate yields on Treasurys are driving bond investors elsewhere to apply their rekindled risk-taking, and thus absolute yields are low on all fixed income instruments. On November 12, The New York Times reported on comments by Martin Feldstein, former president of the National Bureau of Economic Research and chairman of the Council of Economic Advisers under Ronald Reagan: Anticipation of QE2, he wrote in the Financial Times, caused prices of commodities and common stocks to rise. “Like all bubbles, these exaggerated increases can rapidly reverse when interest rates return to normal levels,” he said. “The greatest danger will then be to leveraged investors, including individuals who bought these assets with borrowed money and banks that hold long-term securities. © Oaktree Capital Management, L.P.Reserved

This problem is particularly severe at financial institutions (and what is a national economy today other than a financial system, hopefully with a manufacturing sector tacked on?) Financial institutions are, by definition, marked by high leverage, and if confidence declines, the providers of credit tend to ask for their money back. Since these institutions never have enough cash on hand to satisfy the demands of the would-be withdrawers, they can fall prey to a run on the bank. The first task, then, is to restore confidence and keep capital available. Thus, at the beginning of May, the E.U. put together a rescue package for Greece worth €110 billion. And then, when the possibility of contagion to Spain, Italy and Portugal began to be recognized, that was increased on May 10 to €750 billion (or $900 billion, a figure remarkably similar to the U.S.’s program). In addition, the European Central Bank established a program to buy government bonds of the affected nations, along the lines of our “quantitative easing.” Many European governments have announced plans to reduce deficits. Their tactics include reduced spending, freezes or cuts in public sector employment and wages, and higher retirement ages. Some have enacted tax increases to augment revenues. Greece even says it’s going to start collecting more of the taxes that are owed. Austerity is all the talk in Europe, and some leaders are predicting periods of substantial suffering.

© Oaktree Capital Management, L.P. All Rights Reserved Memo to: Oaktree Clients From: Howard Marks Re: So Much That’s False and Nutty As reported in The New York Times of May 5, Warren Buffett told the crowd at this year’s Berkshire Hathaway annual meeting: There is so much that’s false and nutty in modern investing practice and modern investment banking. If you just reduced the nonsense, that’s a goal you should reasonably hope for. As we look back at the causes of the crisis approaching its second anniversary – and ahead to how investors might conduct themselves better in the future – Buffett’s simple, homespun advice holds the key, as usual. I agree that investing practice went off the rails in several fundamental ways. Perhaps this memo can help get it back on. The Lead-up: Progress and Missteps Memory dims with the passage of time, but when I think back to the investment arena I entered forty-plus years ago, it seems very different from that of 2003-07. Institutional investing was done mainly by bank investment departments (like the one I was part of), insurance companies and investment counselors – a pretty dull bunch. And as I like to point out when I speak to business school classes, “famous investor” was an oxymoron – few investment managers were well known, chosen for magazine covers or listed among the top earners. There were no swaps, index futures or listed options. Leverage wasn’t part of most institutional investors’ arsenal . . . or vocabulary.

© Oaktree Capital Management, L.P. All Rights Reserved Memo to: Oaktree Clients From: Howard Marks Re: The Long View Many of my memos over the last year and a half have touched on the developments in 2003-07 that brought on the current financial crisis. By now, everyone understands the role of innovation, risk tolerance and leverage in the boom that led to the bust, so I think it’s now time to look back considerably further. The Importance of Cycles In my opinion, there are two key concepts that investors must master: value and cycles. For each asset you’re considering, you must have a strongly held view of its intrinsic value. When its price is below that value, it’s generally a buy. When its price is higher, it’s a sell. In a nutshell, that’s value investing. But values aren’t fixed; they move in response to changes in the economic environment. Thus, cyclical considerations influence an asset’s current value. Value depends on earnings, for example, and earnings are shaped by the economic cycle and the price being charged for liquidity. Further, security prices are greatly affected by investor behavior; thus we can be aided in investing safely by understanding where we stand in terms of the market cycle. What’s going on in terms of investor psychology, and how does it tell us to act in the short run? We want to buy when prices seem attractive.

© Oaktree Capital Management, L.P. All Rights Reserved Here’s how Thomas Friedman put it in The New York Times of January 31: Everyone is looking for the guy – the guy who can tell you exactly what ails the world’s financial system, exactly how we get out of this mess and exactly what you should be doing to protect your savings. . . . But here’s what’s really scary: the guy isn’t here. He’s left the building. . . . There is no magic bullet for this economic crisis, no magic bailout package, no magic stimulus. We have woven such a tangled financial mess with subprime mortgages wrapped in complex bonds and derivatives, pumped up with leverage, and then globalized to the far corners of the earth that, much as we want to think this will soon be over, that is highly unlikely. The “I know” school (which first appeared in a memo in 2001) is still making predictions. Statistical comparisons are being made to past recessions and solutions extrapolated from those experiences. Thus it’s the consensus of this school that the recovery will start during the first quarter of 2010. I also see people projecting a stock market rebound based on the average time between past declines and the recoveries therefrom. I think it’s a mistake to hold confident opinions about the events of today. Instead, I think this is a great time to reaffirm faith in the “I don’t know” school, of which I’m a card-carrying member. No one should feel certain they know what’s going to unfold, or when.

© Oaktree Capital Management, L.P. All Rights Reserved but also quite painful. If the world is unwilling to live with such lessons from time to time – and if some institutions are considered to be “too big to fail” for society’s purposes – then free markets and self-interest have to be restrained. Greed may be good, but it can be permitted to run free only up to a point. Nothing’s More Risky Than a Widespread Belief That There’s No Risk The recent crisis came about primarily because investors partook of novel, complex and dangerous things, in greater amounts than ever before. They took on too much leverage and committed too much capital to illiquid investments. Why did they do these things? It all happened because investors believed too much, worried too little, and thus took too much risk. In short, they believed they were living in a low-risk world. In 2006 and early 2007, for instance, we heard a lot about the “wall of liquidity” that was coming toward us from China and the oil producing countries, a flow that could be counted on to provide capital and raise asset prices non-stop. Likewise, we were told (a) the Fed had tamed the business cycle through its adroit management, (b) securitization, tranching and disintermediation had reduced risk by putting it where it could best be handled, and (c) the “Greenspan put” could always be counted on to bail out investors who made mistakes. These and other things were said to have lowered the risk level worldwide.

That changed with the spread of the argument – associated primarily with Michael Milken – that incremental credit risk could responsibly be borne if offset by more-than-commensurate yield spreads.  Around 1980, debt securitization began to occur, with packages of mortgages sliced into securities of varying risk and return, with the highest-priority tranche carrying the lowest yield, and so forth. This process was an example of disintermediation, in which the making of loans moved out of the banks; 25 years later, this would be called the shadow banking system.  One of the first “quant” miracles came along in the 1980s: portfolio insurance. Under this automated strategy, investors could ride stocks up but avoid losses by entering stop-loss orders if they fell. It looked good on paper, but it failed on Black Monday in 1987 when brokers didn’t answer their phones.  In the mid- to late 1980s, the ability to borrow large amounts of money through high yield bond offerings made it possible for minor players to effect buyouts of large, iconic companies, and “leverage” became part of investors’ everyday vocabulary.  When many of those buyouts proved too highly levered to get through the 1990 recession and went bust, investing in distressed debt gained currency.  Real estate had boomed because of excessive tax incentives and the admission of real estate to the portfolios of S&Ls, but it collapsed in 1991-92.

© Oaktree Capital Management, L.P. All Rights Reserved  Quant investing arrived, too, achieving its first real fame with the success of Long- Term Capital Management. This Nobel Prize-laden firm used computer models to identify fixed income arbitrage opportunities. Like most other investment miracles, it worked until it didn’t. Thanks to its use of enormous leverage, LTCM melted down spectacularly in 1998.  Investors’ real interest in the last half of the ’90s was in common stocks, with the frenzy accelerating but narrowing to tech-media-telecom stocks around 1997 and narrowing further to Internet stocks in 1999. The “limitless potential” of these instruments was debunked in 2000, and the equity market went into its first three-year decline since the Great Crash of ’29.  Venture capital funds, blessed with triple-digit returns thanks to the fevered appetite for tech stocks, soared in the late 1990s and crashed soon thereafter.  After their three-year slump, the loss of faith in common stocks caused investors to shift their hopes to hedge funds – “absolute return” vehicles expected to make money regardless of what went on in the world.  With the bifurcation of strategies and managers into “beta-based” (market-driven) and “alpha-based” (skill-driven), investors concluded they could identify managers capable of alpha investing, emphasize it, perhaps synthesize it, and “port” or carry it to their portfolios in additive combinations.

© Oaktree Capital Management, L.P. All Rights Reserved  to use past statistical averages – sometimes covering brief time periods – to gauge the safety of prospective investments,  to partake in financial innovation and invest in things too complex or opaque to be understood,  to believe that risk had been banished, most recently through securitization, tranching and decoupling,  to forgo liquidity,  to make increasing use of leverage (see separate section below),  to finance investment activities with undependable capital: short-term borrowings and deposits, impermanent equity, and future cash receipts,  to forget to worry and be risk-averse, and thus  to accept additional risk at shrinking risk premiums. The “era of increasing willingness” carried many trends to higher highs. The last ten listed above were the prime ingredients giving rise to the current crisis. Together they produced an investment house of cards that was enormously dependent on continued prosperity, bullishness and easy money. Expansiveness In addition to “willingness,” one of the most significant trends during the period under discussion has been a massive increase in “expansiveness,” my new label for the desire to increase the ratio of activity to capital. If that sounds unfamiliar, the common term in America is “leverage,” and in England it’s “gearing.” My last memo was on the subject of leverage and its major role in the crisis we’re all experiencing.

Today’s problems are largely a function of the high levels of leverage employed in 2003-07, but those levels were just the apogee of a progression that spanned decades. Every business, government, non-profit organization or individual has a certain amount of equity capital, net worth or surplus. That capital, in turn, will support a certain level of activity: production and sales, lending, government action, charitable grants or consumption. But over the last several decades, if you wanted to do more of these things than your capital permitted, you could borrow capital from someone else. Over the course of my lifetime, there have been extraordinary changes in the extent of borrowing:  Consumers – When I went off to college 45 years ago, I paid for purchases with checks or cash, and I saved up coins for the payphone. “Travel and entertainment” cards like American Express and Diners Club were available only to those with top credit ratings, and the masses lived without credit cards until Citibank introduced The Everything Card (now MasterCard) around 1967. In the old days, consumers who lived beyond their incomes were often described as being “in debt.hear

” Asked about the issue during his testimony, Greenspan said, “We’ve looked at the bubble question and we’ve concluded that it is most unlikely.” He attributed recent “sizeable gains” in home prices to “the effects on demand of low mortgage rates, immigration and shortages of buildable land.” (Business Wire, July 22, 2002, emphasis added) Ignoring bubbles is a special case of ignoring risk in general. The philosopher George Santayana is famous for having said, “Those who cannot remember the past are condemned to repeat it.” Likewise, those who fail to learn from past bubbles are bound to suffer in the bursting of new ones. The More You Bet, the More You Win When You Win In the years just prior to the crash, obliviousness to risk encouraged numerous forms of risky behavior. One of the greatest was the use of leverage to increase returns, a phenomenon that became widespread. People make investments on the basis of positive expected returns. When the cost of borrowing is below the expected return, using leverage appears certain to magnify the gain. Thus the Las Vegas maxim that heads this section comes into play, and it's that kind of thinking that gives leverage its seductive power. But there’s so much more to leverage than that, and unfortunately the rest is learned only when things go badly. Leverage doesn’t make an investment better; it merely magnifies the gains and losses.

© Oaktree Capital Management, L.P. All Rights Reserved nationalization may be to return companies to private hands, the temptation to run them for political purposes would be immense. Obviously, there are arguments on both sides. One Proposal The other night, I had dinner with my friend Richard Ressler, principal and founder of CIM Group. He has an idea as to how things can be fixed (as usual), and it’s a pretty good one. I’ll summarize below his thoughts on the banking industry:  There are banking institutions which, because of their magnitude and significance, should be supported through deposit insurance, government guarantees and rescues.  These banks should engage only in the prosaic acts of accepting deposits and making loans. They should not take on ultra-high leverage or make exotic investments. And they shouldn’t do business through unregulated, off-balance-sheet subsidiaries.  Institutions that wish to do things that are off-limits to these banks should do so, but without the benefit of government protection. If they want to take on 30-times leverage and pursue proprietary profits, they should bear the consequences themselves.  Thus banking and risky investing should be separated. In The New York Times of February 2, Professor Paul Krugman of Princeton argued that we have to avoid “lemon socialism: taxpayers bear the cost if things go wrong, but stockholders and executives get the benefits if things go right.

© Oaktree Capital Management, L.P. All Rights Reserved of fundamental difficulty, falling asset prices, reduced market liquidity, collateral value tests and margin calls can be the ruination of investors employing leverage. That’s what befell many in the fourth quarter of 2008. In 2003-07, interest rates brought low by the Fed, modest demands for risk premiums on the part of unworried investors, and financial institutions’ competition to lend conspired to make low- cost leverage readily available. That cheap financing (a) convinced people that high leverage was the route to increased returns (even from low-yielding underlying investments), (b) armed all parties for a bidding war for assets, and (c) made people rush to borrow and buy before the river of financing ran dry. The result was a buying spree of massive proportions, the bill for which – in terms of debt maturities, often unpayable – will come due in the next few years. Like just about everything else in investing, leverage is neither good nor bad per se. Used at the right time, in judicious amounts, to purchase low-priced assets, it’s a good thing. But that’s not the story of the pre-crisis years. And that’s a big reason for the trouble we’ve had since. “Risk Means More Things Can Happen Than Will Happen” The above quote from Elroy Dimson of the London Business School helps bring risk into focus.

But that changed with the introduction of high yield bonds, an innovation permitting low-rated issuers to borrow at high interest rates. Before the advent of high yield bonds, companies could be acquired only by companies bigger than themselves. But with high yield bonds, small firms and even wealthy individuals could borrow enough to acquire corporate giants. This created the leveraged buyout industry. In recent years, not only was debt added to capital structures (particularly through buyouts), but equity was subtracted. Buyout companies used borrowed funds to dividend out their owners’ equity and provide quick profits, and non-buyout companies bought back their shares, often using borrowed money. These activities substituted debt for equity in companies’ capital structures, levering up their results and reducing their margin for error. In the current credit crisis, this has led to large-scale capital destruction.  Financial Institutions – Over the decades in question, banks and investment banks moved away from working for interest, fees and commissions as lenders, advisers, brokers and agents. Instead, they went increasingly into positioning (buying or selling blocks of stock to accommodate clients when the market wouldn’t take that side of a trade), proprietary trading (making investments for their own accounts, not on behalf of clients), and creating derivatives (sometimes ending up with a holding), all on the basis of increased leverage.

© Oaktree Capital Management, L.P. All Rights Reserved  Governments – Similarly, governments at all levels learned increasingly to spend borrowed money in addition to their revenues. Federal, state and local debt ballooned to facilitate both capital projects (reasonably) and deficit spending (less reasonably). The Federal debt grew from $1 trillion in 1980 to $11 trillion today. How? In 2003 and 2004, for example, the government spent $1.42 per $1 of income taxes. In this way, the U.S. became a debtor nation, dependent on bond buyers – particularly from abroad – to let it spend beyond its means. Likewise, state and local debt grew from $1.19 trillion in 2000 to $1.85 trillion in 2005, an average increase of 9.2% per year. In an extreme example of unwise innovation, much of the issuance of muni bonds was made possible because weak issuers could obtain bond insurance; few prospective investors, however, looked into the financial strength of the insurers.  Investors in General – Fifty years ago, the main way investors expanded their activities was through the use of “margin,” borrowing from their brokers to buy stock. Initial margin for new purchases was strictly limited to 100% (e.g., at most you could buy $2 worth of stock for every $1 of equity in your account). But Wall Street proved increasingly creative, and in the current decade it came up with products “with the leverage inside.

” These made much more than 100% leverage available to investors without any explicit borrowing. Hedge and arbitrage funds, collateralized loan obligations, collateralized debt obligations, leveraged buyout funds, credit default swaps and other derivatives; all of these delivered participation in highly leveraged investments without requiring the end investor to use margin or take out loans. In what approached a joke, the prim limit on margin was maintained even as regulators declined to apply any limits or regulation to these other investment structures, despite their ability to provide almost infinite leverage.  Institutional Investors – Given their tax-exempt status, pension funds and charitable and educational endowments can’t borrow to increase their returns. But they can (and did) make use of some of the strategies listed above. Institutional investors also employed “portable alpha,” overlaying hedge fund investments with index futures to simulate more-than-100%-invested positions, and they overcommitted to private equity partnerships to ensure their capital would be fully deployed. The use of borrowed money expanded at all levels over the last few decades. This occurred largely without changes in laws or institutions. Instead, the changes were in customs and attitudes, abetted by financial institutions’ innovation of new products.

I’ve often argued that the key to successful investing lies in subjective judgments made by experienced, insightful professionals, not machinable processes, decision rules and algorithms. I love the way Einstein put it: Not everything that can be counted counts, and not everything that counts can be counted. Relying on Ratings My memos on the reasons for the crisis, like “Whodunit” (February 2008), show that there’s more than enough blame to go around and lots of causes to cite. But if you boil it down, there was one indispensable ingredient in the process that led to trillions of dollars of losses: misplaced trust in credit ratings. The explanation is simple:  Competitive pressure for profits caused financial institutions to try to keep up with the leaders. As is normal in good times, the profit leaders were those who used the most leverage.  Thus institutions sought to maximize their leverage, but the rules required that the greatest leverage be used only with investments rated triple-A.  A handful of credit rating agencies had been designated by the government as Nationally Recognized Statistical Rating Organizations, despite their highly imperfect track records.  The people who guard the financial henhouse often have a tough time keeping up with the foxes’ innovations.relatively

The use of leverage illustrates a special case of the above. Leverage increases the gains if you succeed and the losses if you fail. Thus leverage increases the probability of maximizing under favorable outcomes and reduces your margin of safety under unfavorable ones.and

Of all the investment adages I use, this one remains the most important: “What the wise man does in the beginning, the fool does in the end.” Practices and innovations often move from exotic to mainstream to overdone, especially if they’re initially successful. What early investors did safely, the latecomers tried in 2003-07 with excessive leverage applied to overpriced and often inappropriate assets. As I wrote in “It’s All Good” (July 2007), leverage was the “ketchup” of this period, used to make unattractive underlying investments appear tasty. The results have been disastrous.

© Oaktree Capital Management, L.P. All Rights Reserved Here’s another way to put it, from The Wall Street Journal of November 24, When it comes to booms gone bust, “over-investment and over- speculation are often important; but they would have far less serious results were they not conducted with borrowed money.” That statement wasn’t made in reference to current events; that was Irving Fisher writing 76 years ago (“The Debt-Inflation Theory of Great Depressions,” Econometrica, March 1933). Borrowed money lets economic units expand the scale of their activity. But it doesn’t add value or make things better; it just makes gains bigger and losses more painful. There’s an old saying in Las Vegas: “The more you bet, the more you win when you win.” But they always forget to add “. . . and the more you lose when you lose.” In one of those beautiful phrasings that demonstrate his mastery of language, Jim Grant of Grant’s Interest Rate Observer has described liquidity and leverage as “money of the mind.” By this he means they’re intangible and ephemeral, not dependable like assets or equity capital. Someone may lend you money one day but refuse to renew your loan when it comes due. Thus, leverage is purely a function of the lender’s mood. The free-and-easy lending of 2003-07 has turned into an extreme credit crunch, and the unavailability of credit is both the root and the hallmark of today’s biggest problems.

© Oaktree Capital Management, L.P. All Rights Reserved technical reasons. Loan investors who were able to hold on recovered, but many who had bought with leverage couldn’t do so. They drowned in the deep part of the stream. Chuck Prince on Dancing A quotation from the former CEO of Citigroup contains just 30 words, but it could serve as a case study regarding the events leading up to the crash: When the music stops, in terms of liquidity, things will be complicated. But as long as the music is playing, you’ve got to get up and dance. We’re still dancing. (Charles Prince, July 9, 2007) I suspected in mid-2007 that this quotation would end up being emblematic of the cycle. It’s been replayed many times, but usually without the first dozen words. Prince seems to have been more aware of what was going on than people give him credit for. He may have sensed the bank was on thin ice in lending and levering, like the rest. The problem wasn’t that he overlooked the danger; the problem was that he felt he had to participate anyway. One of the dilemmas faced by businesses is that they can conclude that they have no choice but to take part in dangerous behavior. Usually this is because they’re unwilling to cede market share. On October 5, Leo Strine, Vice Chancellor of the Delaware Court of Chancery, wrote as follows in The New York Times Dealbook: . . .

Those who expand the scope of their operations on the basis of borrowed money should always consider the possibility that lenders will change their mind. Use of Debt in the Corporate World Note three things regarding debt. First, all businesses borrow. Debt is used broadly to finance things ranging from inventories to capital investment. If companies had to wait to get paid by buyers before ordering new goods to sell, business would go much slower. And if all their capital had to be equity, capital would be much more costly and companies would be much smaller. Borrowing makes the business world go ’round. Second, debt is rarely repaid. Businesses rarely reduce their total indebtedness. Rather than being paid off, debt is simply rolled over. That makes the solvency of the borrowers contingent on the continuous availability of credit. Third, given that the yield curve normally slopes upward, short-term borrowing is almost always the least expensive. That’s what led First National City Bank to invent commercial paper in the 1960s, enabling companies to borrow at short-term rates through short-dated paper that would be renewed every month or so. The upward slope of the yield curve encourages people to borrow short even when investing long, resulting in economic maximization when they’re able to roll over their debts but disaster when they aren’t.

© Oaktree Capital Management, L.P. All Rights Reserved The More You Bet . . . If I had to choose a single phrase to sum up investor attitudes in 2003-07, it would be the old Las Vegas motto: “The more you bet, the more you win when you win.” Casino profits ride on getting people to bet more. In the financial markets just before the crisis, players needed no such encouragement. They wanted to bet more, and the availability of leverage helped them do so. One of the major trends embedded in the chronology on pages two and three was toward increasing the availability of leverage. Now, I’ve never heard of any of Oaktree’s institutional clients buying on margin or taking out a loan to make investments. It might not be considered “normal” for fiduciaries, and tax-exempt investors would have to worry about Unrelated Business Taxable Income. None of us go out and buy Intel chips, but we’ve all seen commercials designed to get us to buy products with “Intel inside.” In the same way, investors became increasingly able to buy investment products with leverage inside . . . that is, to participate in levered strategies rather than borrow explicitly to make investments. Think about these elements from my earlier list of investment developments:  Investors who would never buy stocks on margin were able to invest in private equity funds that would buy companies on leverage of four times or more.

© Oaktree Capital Management, L.P. All Rights Reserved purported risk-reducers described on page 2 above, investors generally ignored the risk of loss. In those heady times, they feared only missing opportunities, looking too conservative, and losing business. This combination spurred them to employ aggressive strategies, innovative products, leverage and illiquidity. When most people think the worst imaginable outcome is failing to participate fully in gains, the result is risky behavior. They’re inevitably reminded that there’s worse, but it can take a long time to happen. “It’s Only When the Tide Goes Out That You Find Out Who’s Been Swimming Naked” When I came across the above quotation from Warren Buffett, I borrowed it for “It’s All Good” (July 16, 2007) and later devoted an entire memo to it (“The Tide Goes Out,” March 18, 2008). Buffett’s way of saying things combines brevity, humor and pinpoint accuracy, and this is a great example. Financial innovation was a major component in building the base for the crisis. As I’ve said before, popularization of new investment products is possible only in rising markets, with their suspension of skepticism, easy access to money, and dearth of trying moments. On the other hand, innovations are only tested in falling markets, and few pass the ultimate test. Californians’ homes may contain construction flaws, but we only learn about them during earthquakes.

 The delayed and irregular nature of drawdowns caused people who had earmarked $100 for private investment funds to make commitments totaling $140.  Options, swaps and futures – in fact, many derivatives – are nothing but ways for investors to access the return on large amounts of assets with little money down.  Many hedge funds used borrowings or derivatives to access the returns on more assets than their capital would allow them to buy.  When people wanted to invest $100 in markets with skill-derived return bolted on, “portable alpha” had them invest $90 in hedge funds with perceived alpha and the rest in futures covering $100 worth of the passive market index. This gave them a stake in the performance of $190 of assets for every $100 of capital. Clearly, each of these techniques exposed investors to the gains or losses on increased amounts of assets. If that’s not leverage, what is? In fact, an article entitled “Harvard Endowment Chief Is Earning Degree in Crisis Management” in The New York Times of February 21 said of Harvard, “The endowment was squeezed partly because it had invested more than its assets . . .” (emphasis added). I find this statement quite remarkable, and yet no one has remarked on it to me. It shouldn’t be surprising that people engaging in these levered strategies made more than others when the market rose. But 2008 showed the flip side of that equation in action.

Likewise, a fatally flawed investment product can easily survive until it’s tested in a bear market. The extensive investment innovation of 2003-07 was driven by the poor performance of stocks in 2000-02 and the low yields available on high grade bonds. A large number of new products and strategies emerged, increasing in popularity in a salutary environment. Few investors were troubled by the products’ dependence on high leverage or suddenly commonplace triple-A ratings, or by the fact that they hadn’t been tested in tough times. It’s not surprising that bull market developments were defrocked in the tougher times of 2007- 08, but it’s somewhat shocking how many examples there are. It turned out that:  losses on investments involving leverage, illiquidity or risky assets could be much worse than the “worst case” that had been predicted,  beta had been confused for alpha, just as leverage had for value added,  there was nothing absolute about “absolute return,” and “market neutral” strategies were correlated with the market,  the “golden age of private equity” had been a function of easy money, not bargain purchases,  sharing the upside with investment managers isn’t sufficient to align their interests with those of their clients, and  things that “should happen” often don’t. While an extreme case, the story of Bernie Madoff presents an apt example of this phenomenon.

© Oaktree Capital Management, L.P. All Rights Reserved Then reality struck, and it turned out that the worriers had been right all along. The surge in asset values had been an illusion – but the surge in debt had been all too real. . . . . . . this is a broad-based mess. Everyone talks about the problems of the banks, which are indeed in even worse shape than the rest of the system. But the banks aren’t the only players with too much debt and too few assets; the same description applies to the private sector as a whole. As the great American economist Irving Fisher pointed out in the 1930s, the things people and companies do when they realize they have too much debt tend to be self-defeating when everyone tries to do them at the same time. Attempts to sell assets and pay off debt deepen the plunge in asset prices, further reducing net worth. Attempts to save more translate into a collapse of consumer demand, deepening the economic slump. . . . Government officials understand the issue: we need to “contain what is a very damaging and potentially deflationary spiral,” says Lawrence Summers, a top Obama economic adviser. Debt has to be reduced, and it’s happening (other than at the federal level, of course). But the way it happens is usually unpleasant: bankruptcies, foreclosures and debt restructurings. “Debt reduction” sounds like a good thing, but it’s likely to be accompanied by the painful loss of the assets that had been bought with borrowed money.

© Oaktree Capital Management, L.P. All Rights Reserved Sharing the Wealth Apart from the increasing use of leverage, another trend that characterized the five years before the crisis was the widespread imposition of incentive fees. In the 1960s, at the start of my chronology, only hedge funds commanded incentive fees, and there were too few for most people to know or care about. But fee arrangements that can be simplified as “two-and-twenty” flowered with private equity in the 1980s, distressed debt, opportunistic real estate and venture capital funds in the 1990s, and hedge funds in the 2000s. Soon they were everyplace. Here are my basic thoughts on this sort of arrangement. (Oaktree receives incentive compensation on roughly half its assets; my objection isn’t with regard to the fees themselves, but rather the way they’ve been applied.)  It seems obvious that incentive fees should go only to managers with the skill needed to add enough to returns to more than offset the fees – other than through the mere assumption of incremental risk. For example, after a high yield bond manager’s .50% fee, a 12% gross return becomes 11.5% net. A credit hedge fund charging a 2% management fee and 20% of the profits would have to earn a 16.375% gross return to net 11.5%. That’s 36% more return. How many managers in a given asset class can generate this incremental 36% other than through an increase in risk? A few? Perhaps. The majority? Never.

it’s improbable events that brought on the credit crisis. Lots of bad things happened that had been considered unlikely (if not impossible), and they happened at the same time, to investors who’d taken on significant leverage. So the easy explanation is that the people who were hurt in the credit crisis hadn’t been skeptical – or pessimistic – enough. But that [realization] triggered an epiphany: Skepticism and pessimism aren’t synonymous. Skepticism calls for pessimism when optimism is excessive. But it also calls for optimism when pessimism is excessive. (“The Limits to Negativism,” October 15, 2008) The swing of the pendulum to one extreme or another is a constant in the investment world: from optimism to pessimism, from credulous to skeptical, from sanguine to panicked, from wide-open capital markets to windows slammed shut, from more buyers than sellers to more sellers than buyers and, consequently, from overpriced to underpriced. Thus I was thrilled when an article by my friend James Grant provided a quotation that beautifully sums up the end result of this process: To the English economist Arthur C. Pigou is credited a bon mot that exactly frames the issue. “The error of optimism dies in the crisis, but in dying it gives birth to an error of pessimism. This new error is born not an infant, but a giant.” (The Wall Street Journal, September 19, 2009, emphasis added) Optimism thrives in bubbles.

Investors can eliminate one or the other, but not both. More commonly, they must consider how to balance the two. How they do so will have a great impact on their results. This is the old dilemma – fear or greed? – that people talk about so much. It’s part of the choice between offense and defense that I often stress (see, for example, “What’s Your Game Plan?” September 2003). The problem is that investors often fail to strike an appropriate balance between the two risks. In a pattern that exemplifies the swing of the pendulum from optimistic to pessimistic and back, investors regularly oscillate between extremes at which they consider one to the exclusion of the other, not a mixture of the two. One of the ways I try to get a sense for what’s going on is by imagining the conversations investors are having with each other . . . or with themselves. In 2003-07, with most investors worried only about achieving returns, I think the conversation went like this: “I’d better not make less than my peers. Am I behaving as aggressively as I should? Am I using as much leverage as my competitor? Have I shifted enough from stocks and bonds to alternatives, or am I being an old fogey? If my commitments to private equity are 140% of the amount I actually want to invest, is that enough, or should I do more?” Few people seemed to worry about losses. Or if they were worried, they played anyway, fearing that if they didn’t, they’d be left behind.and

But I’d rather have 10%. 14% would be great, and the possibility of 16% warrants adding to my risk. It’s worth using leverage for a shot at 20%, and with twice as much leverage, I might get 24%.” In other words, more is better. And of course it is . . . except that to pursue higher returns, you have to give up something. That something is safety. But in hot times, no one worries about losing money, just missing out. So they try to maximize. There should be a point at which investors say, “I need 8%, and it would be great if I could get 16%. But to try, I would have to do things that expose me to excessive loss. I’ll settle for a safer 10% instead.” I’ve labeled this concept “good-enough returns.” It’s based on the belief that the possibility of more isn’t always better. There should be a point at which investors decline to take more risk in the pursuit of more return, because they’re satisfied with the return they expect and would rather achieve that with high confidence than try for more at the risk of falling short (or losing money). Most investors will probably say that in 2003-07, they didn’t blindly pursue maximization; it was the other guys. But someone did it, and we’re living with the consequences. I like it better when society balances risk and return rather than trying to maximize. Less gain, perhaps, but also less pain.

Memo to: Oaktree Clients From: Howard Marks Re: The Tide Goes Out For every period, there’s a quotation which serves perfectly to explain what’s going on, and I often find myself borrowing it. Warren Buffett provides more than his share; not only is his insight unmatched, but so is his ability to express it. Thus, starting with “It’s All Good” last July, I’ve found frequent use for this one: When the tide goes out, we find out who’s been swimming without a bathing suit. Certainly, “swimming without a bathing suit” – or perhaps a life preserver – serves beautifully to describe investor behavior during the carefree period that ended last summer. And equally, the ebbing of the tide – and the exposing of those who engaged in that behavior – sums up the unpleasant disclosures which have taken place since. Financial sector participants indulged in unprecedented amounts of leverage, innovation and risk taking between late 2002 and mid-2007, the consequences of which have become readily apparent. Leveraging and Inflating When we look at the last few years, we see a rather ordinary period of economic growth and prosperity, accompanied by good corporate health and profitability. But what distinguished this period from all others was a runaway boom in financial sector activity. The whole financial sector inflated, like a balloon into which increasingly more hot air was forced.

© Oaktree Capital Management, L.P. All Rights Reserved Memo to: Oaktree Clients From: Howard Marks Re: Volatility + Leverage = Dynamite Nearly fifteen years ago, in April 1994 – at a time when absolutely no one was reading my memos – I published one called “Risk in Today’s Markets Revisited.” That’s when I first proposed the formula shown above. I recycled it in “Genius Isn’t Enough,” on the subject of Long-Term Capital Management (October 1998). The last few years have provided a great demonstration of how dangerous it can be to combine leverage with risky assets, and that’s the subject of this memo. It’ll also pick up on some ideas from my last memo, “The Limits to Negativism.” My memo “Plan B” on the bailout proposal went out on September 24, and as I lay in bed later that night, I realized that I hadn’t taken one part of it nearly far enough. In discussing a prime cause of the credit crisis, I wrote the following: I’ll keep it simple. Suppose you have $1 million in equity capital. You borrow $29 million and buy $30 million of mortgage loans. Twenty percent (or $6 million) of the mortgages go into default, and the recovery on them turns out to be only two-thirds ($4 million). Thus you’ve lost $2 million . . . your equity capital twice over. Now you have equity capital of minus $1 million, with assets of $28 million and debt of $29 million.

Everyone realizes that there’ll be nothing left for the people who’re last in line to withdraw their money, so there’s a run on the bank. And you slide into bankruptcy. That’s true as far as it goes, but I’m going to devote this memo to things which could have followed that paragraph. UThe Problem at Financial Institutions It’s no coincidence that today’s financial crisis was kicked off at highly leveraged banks and investment banks. The paragraph above shows why that’s true, and why the problem is as big as it is. As I wrote in “Plan B”: Because of the high regard in which financial institutions were held; because of the implied government backing of Fannie Mae and Freddie Mac; and because permissible leverage increased over time, financial institutions’ equity capital was permitted to become highly inadequate given the riskiness of the assets they held.say

The greatest contributor to the 2002-07 boom likely was leverage; the recent past saw a steady flow of equity capital to levered entities, accompanied by willingness on the part of lenders to provide unprecedented amounts of leverage. Now the reversal of that process is underway, with consequences that are equally dramatic but much less pleasant. Let’s review the process which was often described and embraced as a virtuous circle:  Equity capital was provided to would-be leveraged entities.  Debt was readily available for them to use in expanding their total capital and thus their ability to pursue profit.  This combined capital was used to purchase assets, forcing prices higher.  Price appreciation caused the entities’ equity to expand at a faster rate thanks to their financial leverage. © OAKTREE CAPITAL MANAGEMENT, L.P. ALL RIGHTS RESERVED.

Further, the entire economy runs on trust: that the people to whom we provide goods and services will pay their bills; that contracts will be adhered to; and that money will retain value, or at least the part that inflation doesn’t erode. Belief is what makes the economic world go round. Take a minute to think about how we would behave in a world in which there wasn’t trust in money, the institutions that store it and the mechanisms that move it from one place to another. Clearly, we’d be sunk without trust in the financial system. I’ve described in the past how financial institutions are vulnerable to loss of faith because of their unique combination of opacity, leverage, conscious risk bearing, and their use of short-term deposits and borrowings to fund longer-term, illiquid assets. When providers of capital lose faith in a financial institution, they line up to withdraw their money. But the institution can’t give them all back their money, because it can’t liquify all of its assets immediately.downward

equities having fallen for three consecutive years for the first time since the Great Depression – many investors concluded that their return aspirations couldn’t be met in traditional investments. Pressure for higher returns had the effect of increasing the acceptance of alternative investments, hedge funds, emerging market securities, leverage and financial innovation . . . in the process, suppressing customary risk aversion.  Leverage and risk taking became the dominant features of the financial landscape, facilitated by a “global wall of liquidity.” The low promised return on most investments, the pressure for more and the availability of low-cost capital all combined to make leveraged structures the flavor of the day.  Importantly, much of the growth in leverage took place free of regulatory oversight. In the past, the creation of debt was limited by margin requirements, Fed regulations, bank capital requirements and bankers’ prudence.an

© Oaktree Capital Management, L.P. All Rights Reserved explosion of non-bank lending rendered the traditional restraints impotent, with unregulated hedge funds and derivative traders doing what financial institutions wouldn’t or couldn’t. And when traditional providers of capital did participate, competition to lend caused them to join in the trend to “covenant-lite,” “PIK/toggle” and other loosey-goosey structures.  Financial innovation enjoyed enormous popularity. The application of leverage, securitization and tranching permitted debt backed by assets such as mortgages to be created and sold around the world. This process, it was said, enabled just the right level of risk and return to be delivered to each investor.  Financial sector participants and observers concluded that the world had been made a less risky place by disintermediation (in which banks sold off loans rather than hold them), adroit central bank management and developments that made debt more borrower-friendly. In many cases, this sense of reduced risk encouraged individuals to assume correspondingly more risk.  Because the structured products were so new, sophisticated and opaque, high ratings would be needed if they were to gain acceptance. Wall Street’s persuasiveness, combined with the rating agencies’ susceptibility, caused the needed ratings to be assigned. Thus the final element was in place for the financial innovations to gain widespread popularity.

© Oaktree Capital Management, L.P. All Rights Reserved UHow Things Got This Way Much of the current problem can be attributed to a decades-long bubble in the financial sector that made it the employer of obvious choice; attracted employees who were “the best and the brightest” (although often untrammeled by experience); contributed to greed and risk taking; drove out fear and skepticism; and carried institutions, behavior, expectations and asset prices to unsustainable levels. What are the factors that got us in the current mess?  Excess liquidity, which had to find a home.  Interest rates that had been reduced to stimulate the economy.  Dissatisfaction with the resulting prospective returns on low-risk investments.  Inadequate risk aversion, and thus a willingness to step out on the risk curve in search of higher returns.  A broad-scale willingness to try new things, such as structured products and derivatives, and to employ massive leverage.  A desire on the part of financial institutions to supplement operating income with profits from proprietary risk taking – that is, to be “more like Goldman.”  A system of disintermediation, selling onward, and slicing and dicing that caused many participants to overlook risk in the belief that it had been engineered away.  Excessive reliance on rating agencies which were far from competent to cope with the new instruments, and on black-box financial models that extrapolated recent history.

© Oaktree Capital Management, L.P. All Rights Reserved For forty years I’ve seen the manic-depressive cycle of investor psychology swing crazily: between fear and greed – we all know the refrain – but also between optimism and pessimism, and between credulity and skepticism. In general, following the beliefs of the herd – and swinging with the pendulum – will give you average performance in the long run and can get you killed at the extremes. Two or three years ago, the world was so different as to be almost beyond remembering. It was ruled by greed, optimism and credulity. In short, it was the opposite of the last few weeks: no story was too positive to be believed.  “There’s a worldwide ‘wall of liquidity’ that can never dry up.”  “Triple-A CDOs are as safe as triple-A corporate debt but will deliver higher returns.”  “Leverage holds the key to better investment results.”  “Tranching and selling onward are spreading the risk, thereby eliminating it.”  “Decoupling has reduced nations’ economic reliance on the U.S.” Boy, what a good time that was for a dose of skepticism! What benefits it could have provided (in terms of losses avoided). But when conventional wisdom is rosy, few can stand against it. People who do so too early look woefully wrong and are swept aside. That discourages others from trying the same thing, even as the cycle swings further to the positive extreme.

 The increases in equity were matched by further increases in borrowings.  In fact, the good performance convinced lenders to increase the amount of leverage they would supply per dollar of equity. This meant the entities could grow their portfolios even faster than the rates at which equity capital flowed in and assets appreciated.  Further, because of the seeming impregnability of the leveraged entities’ profitability, risk aversion shrank and the risk premiums and returns demanded by lenders declined. Leverage became cheaper and thus even more attractive.  As is typical of virtuous circles, everything ran smoothly . . . for a while: additional equity flowed in; it was leveraged up increasingly; buying caused assets to appreciate further; and the upward spiral continued. With things working increasingly well and investors becoming more and more excited, processes like this one seem destined to go on forever. Of course, they cannot. But people forget that, satisfying one of the key prerequisites for a cycle that goes to excess. Overestimating the longevity of up legs and down legs is one of the mistakes that investors insist on repeating. Deleveraging and Deflating Over the years I’ve written a number of memos about cycles, and in each one I’ve tried to remind readers that trees don’t grow to the sky, and that success carries within itself the seeds of failure.

© Oaktree Capital Management, L.P. All Rights Reserved institutions took on too many risky assets given the limitations of their equity capital. That, in a nutshell, is why institutions have disappeared. So what exactly did these institutions do wrong? Here are a few examples, using Bank X, with $10 billion of capital, to illustrate:  Bank X uses leverage to buy $100 billion of triple-A mortgage-related debt, under the assumption that it can’t lose more than 1%. Instead, home prices decline nationwide, causing it to write down its holdings by 10%, or $10 billion. Its capital is gone.  Alternatively (but in fact probably simultaneously), Bank X sells Hedge Fund G $10 billion of credit default swaps on the bonds of Company A, and it buys $10 billion of the same credit protection from Investment Bank H. Company A goes bankrupt, and Bank X pays Hedge Fund G $10 billion. But Investment Bank H goes bankrupt, too, so Bank X can’t collect the $10 billion it’s due. Its capital is gone.  Bank X lends $50 billion to Hedge Fund P with equity of $10 billion, which then buys $60 billion of securities. The value of the fund’s portfolio falls to $50 billion; the bank sends a margin call; no additional collateral can be posted; so the bank seizes and sells out the portfolio. But in the downward-spiraling market, the bank only realizes $40 billion. Its capital is gone.  Hedge Fund Q also borrowed to buy securities.

 A boom in home prices and a belief that they couldn’t fall back en masse.  Securitization and selling onward of debt – which eliminated lenders’ hesitance to lend and led to a process in which everyone profited when a loan was made.  Thus an increased willingness to lend higher percentages of the skyrocketing prices of homes, even where the borrower couldn’t demonstrate creditworthiness.  Widespread use of leverage (because the risks were underrated) and complexity in fashioning mortgage-backed securities.  Massive shortcomings at rating agencies that erroneously described the resulting securities as investment grade, and sometimes even “super senior.” In this way, enormous amounts of overrated securities came to the market. They went to financial institutions that didn’t understand the riskiness of what they were buying and thus permitted themselves to become vastly overleveraged. I’ll keep it simple. Suppose you have $1 million in equity capital. You borrow $29 million and buy $30 million of mortgage loans. Twenty percent (or $6 million) of the mortgages go into default, and the recovery on them turns out to be only two-thirds ($4 million). Thus you’ve lost $2 million . . . your equity capital twice over. Now you have equity capital of minus $1 million, with assets of $28 million and debt of $29 million. Everyone realizes that there’ll be nothing left for the people who’re last in line to withdraw their money, so there’s a run on the bank.

Just as the balloon of levered entities expanded beyond reason in the last few years, now it’s well into the process of deflating. And, as I mentioned in “Now What?” the air always goes out a lot faster than it went in. Eventually, developments that are exogenous to the process interfere, or perhaps the process collapses of its own weight. In the current instance, consider subprime mortgages. The process described above was going along just fine, with increasing numbers of ever-larger mortgages being granted to cover a rising percentage of the cost of houses bought at rising prices by borrowers of declining creditworthiness. So far, so good: a process unhampered by discipline or restraint. But it must be seen that, eventually, reality will intrude. For example, eventually the amounts borrowed will necessitate payments that exceed what the borrowers can afford. Oops; investors forgot that part. To understand what’s going on now, all you have to do is reverse the process described above and squeeze (the squeeze – the force behind the deflating – comes from the pain that accompanies disclosure of the process’s flaws).  Something causes asset prices to weaken.  Now the leverage works in reverse, causing the entities’ equity to shrink faster than the rate of decline in asset prices, and their ratios of borrowings to assets to rise.  Lenders, worried about declining asset prices, either call in their loans or refuse to roll over debt when it matures.

When Hedge Fund P got its margin call and its portfolio was sold out, that forced securities prices downward. So Fund Q – which holds many of the same positions – also receives a margin call, perpetuating the downward spiral and bringing more losses to more institutions. All of these scenarios, and many others, are connected by a common thread: the combination of leverage and illusory safety, which allowed institutions to take on too much risk for the amount of capital they had. First, it should be clear from the above that the amount of borrowed money – leverage – that it’s prudent to use is purely a function of the riskiness and volatility of the assets it’s used to purchase. The more stable the assets, the more leverage it’s safe to use. Riskier assets, less leverage. It’s that simple. One of the main reasons for the problem today at financial institutions is that they underestimated the risk inherent in assets such as home mortgages and, as a result, bought too much mortgage-backed paper with too much borrowed money. Let’s go back to the paragraph on page one. Here it is again: I’ll keep it simple. Suppose you have $1 million in equity capital. You borrow $29 million and buy $30 million of mortgage loans. Twenty percent (or $6 million) of the mortgages go into default, and the recovery on them turns out to be only two-thirds ($4 million).$2

© Oaktree Capital Management, L.P. All Rights Reserved Understanding this, companies face great pressure to emphasize short-term results. What might they do in response?  Maximize revenues (perhaps by stuffing pipelines and offering discounts that accelerate future sales into the present).  Minimize expenses in slow-to-bloom areas like research and development.  Borrow to buy back stock, because debt capital is cheap and equity is expensive (despite the fact that equity provides safety and leverage amplifies risk). Do you want your companies doing these things? Probably not. But do the collective external pressures force companies in these directions? Absolutely. The things that maximize profits in the short run often serve to decrease profits and increase risk in the long run, but they can be mandatory these days. Investors are increasingly short-sighted, and none more so than some hedge funds, with their emphasis on year-by-year incentive fees. The average stock might deliver a return roughly in line with the growth in corporate profits, and the stocks of better companies should outperform in the long run, but hedge funds (and their investors) expect more. They’re strongly motivated to hold a subset of stocks that will be the best near-term performers. One approach is to take positions and then pressure companies to “maximize shareholder value.

© Oaktree Capital Management, L.P. All Rights Reserved consumer incomes, propelling the economy ahead but rendering households increasingly leveraged. As this process moved onward, it depended on a continued supply of the underlying ingredients: confidence, liquidity, leverage, risk tolerance and acceptance of untested structures. The resulting “virtuous circle” was described in glowing terms just as its perpetuation was growing increasingly unlikely. Bust It took five years or so for the bullish background described above to be established in full. As usual, far less time was required for the excesses to be exposed and the process of their unwinding to begin. The air always goes out of the balloon a lot faster than it went in. Regular readers know that if there’s one thing I believe in, perhaps more strongly than anything else, it’s the fact that cycles will prevail and excesses will correct. For the bullish phase described above to hold sway, the environment had to be characterized by greed, optimism, exuberance, confidence, credulity, daring, risk tolerance and aggressiveness. But these traits will not govern a market forever. Eventually they will give way to fear, pessimism, prudence, uncertainty, skepticism, caution, risk aversion and reticence. A lot of this has happened. Busts are the product of booms, and I’m convinced it’s usually more correct to attribute a bust to the excesses of the preceding boom than to the specific event that sets off the correction.

© Oaktree Capital Management, L.P. All Rights Reserved million . . . your equity capital twice over. Now you have equity capital of minus $1 million, with assets of $28 million and debt of $29 million. Everyone realizes that there’ll be nothing left for the people who’re last in line to withdraw their money, so there’s a run on the bank. And you slide into bankruptcy. Suppose you set up your leveraged portfolio as described but only 2% of your mortgage holdings go bad, not 20%. Then, you only lose $200,000 (not $2 million) of your $1 million of equity, and you’re still solvent. Or suppose 20% of your mortgages default as in the original example, but you only levered up ten times, not 30. You lose the same 6.7% of your assets, but based on $10 million, so it’s just $670,000, or two-thirds of your equity. You’re still alive. The problem lies entirely in the fact that the institutions combined highly risky assets with a large amount of leverage. By now, everyone recognizes (a) how silly it was for the financial modelers to be so sure there couldn’t be a nationwide drop in home prices (they felt that way because there never had been one – but did their data include the Depression?) and (b) the terrible job the agencies did of rating mortgage-related securities. So the risk was underestimated, permitting the leverage to become excessive: end of story. Reason number one for today’s problem, then, is the mismatch institutions turned out to have made between asset risk and leverage.

© Oaktree Capital Management, L.P. All Rights Reserved Because of the high regard in which financial institutions were held; because of the implied government backing of Fannie Mae and Freddie Mac; and because permissible leverage increased over time, financial institutions’ equity capital was permitted to become highly inadequate given the riskiness of the assets they held. Or perhaps I should say institutions took on too many risky assets given the limitations of their equity capital. That, in a nutshell, is why institutions have disappeared. The second fundamental factor leading up to the current mess was the creation of the vast market in derivatives, especially credit default swaps (CDS). In the current decade, CDS came into broad use as a mechanism for insuring against defaults. For an up-front fee and an annual premium, holders of debt could get someone else to promise that they’d buy that debt at face value in the case of a default or other “credit event.” The buyers of CDS accepted at face value that the writers of the insurance would pay if there was a default. For this reason, because Bank A had bought insurance on Company X’s debt from Hedge Fund B, it considered it safe to sell insurance to Bank C. But what if X defaults and A has to pay C but can’t collect from B? There’s over $60 trillion of CDS outstanding, and a lot of it is well hedged in theory; thus the net exposure to defaults if everyone pays might be rather small.

© Oaktree Capital Management, L.P. All Rights Reserved Skepticism is what it takes to look behind a balance sheet, the latest miracle of financial engineering or the can’t-miss story. The idea being marketed by an investment banker or broker has been prettied up for presentation. And usually it’s been doing well, making the tale more credible. Only a skeptic can separate the things that sound good and are from the things that sound good and aren’t. The best investors I know exemplify this trait. It’s an absolute necessity. UThe White Swan Most people probably took away from The Black Swan the same lessons I did (and the lessons mentioned in “The Aviary”): “unlikely” isn’t the same as “impossible,” and it’s essential for investors to be able to get through the low spots. Of course, it’s improbable events that brought on the credit crisis. Lots of bad things happened that had been considered unlikely (if not impossible), and they happened at the same time, to investors who’d taken on significant leverage. So the easy explanation is that the people who were hurt in the credit crisis hadn’t been skeptical – or pessimistic – enough. But that triggered an epiphany: USkepticism and pessimism aren’t synonymous. Skepticism calls for pessimism when optimism is excessive. But it also calls for optimism when pessimism is excessiveU. I’ll write some more on the subject, but it’s really as simple as that.

In every corner, the cry was “let the market decide.” Clearly, however, the events of recent years attest to excesses prompted by the profit motive. More was better: more leverage, more innovation, higher ratings for a given security and more activity in areas like residential real estate. Equally clearly, not all of the free- market decisions were salutary; the proof can be found in the fact that laissez-faire has landed us in a financial crisis that some observers consider the potentially most serious since the Depression. How can we reconcile theory and practice: the way free-market decisions are supposed to work and the way they do work? The answer lies, I think, in the difference between short term and long, and in the coexistence of beneficial general trends and harmful exceptions. Free markets allocate resources efficiently in the long run. But they can’t make the tide rise continually, and while some boats rise, others will crash. Properly functioning free markets will give rise to times that set the stage for ruin, and then to times of ruin itself. They must create losers as well as winners, and capital destruction as well as capital creation. In pursuit of profit in a free market, people can engage in any behavior that’s not illegal. (Well, actually, they can do illegal things too, but hopefully not for long.) Ethical considerations constrain some but not all, and ethicality seems to wax and wane. There’s no doubt that profit pursuers sometimes push the envelope.

© Oaktree Capital Management, L.P. All Rights Reserved Most people are behaving as if there’s no such thing as investing safely in a financial institution. This widespread belief has the ability to greatly delay the restoration of faith, capital and viability. Peter Bernstein put it succinctly in The New York Times of September 28. (Peter’s one of the very wisest men around, in part because he’s one of the few who can talk about the Depression from experience. I recommend his op-ed piece, “What’s Free About Free Enterprise?”) This time around, assets are evidently so rotten in so many places that no financial institution wants to risk doing business with any other financial institution without a government backstop. That’s the reason why no buyer could be found for Lehman Brothers over the weekend preceding its bankruptcy. No one could assess its assets and get comfortable regarding the status of its highly levered net worth, so everyone required a government backstop . . . which wasn’t forthcoming. UThe Right Level of Leverage Although I communicate primarily in words, I tend to think a lot in pictures – certainly more than in numbers. My concept of appropriate leverage can easily be demonstrated through a few diagrams. I’m going to overlook the differences between accounting value, market value and economic value and confuse the terms. But I think you’ll get the idea. The drawings below show the value of companies of different types.

In this decade’s up years, since that bank was required to mark them to market, it was able to expand its balance sheet, and thus its operations, as assets appreciated in the virtuous circle. Equally, contracting asset values now mean the bank’s portfolio is worth less, and that its equity is smaller and can support less debt and thus less lending. Loan portfolios have to be reduced, and new loans can’t be made. A bank’s regulatory capital can become insufficient; it’s this, in part, that has been behind the banks’ trips to sovereign wealth funds for re-equitization. Since they operate in a world that combines rigid regulatory capital requirements, high leverage, fluctuating asset prices and, now, mark-to-market accounting, financial institutions can fail to be viable in extreme bear markets. (And as The Wall Street Journal of March 6 said, “What’s the difference between a hedge fund and a bank? Banks are more highly leveraged.”) In 1990, when high yield bonds had the brush with difficulty described above (meaning spreads widened to 1,100 basis points, and a law was passed that required S&Ls to reflect price declines on their balance sheets), I was asked to brief the board of TCW on the risks. I presented a parable about a regulated financial institution that went bankrupt under the weight of mark-to-market accounting.

© Oaktree Capital Management, L.P. All Rights Reserved Now let’s combine the two concepts. The bottom line is that in order for a company to avoid insolvency, its financial structure has to be such that its value won’t fall through the equity and into the debt. In naïve and far-from-technically correct terms, when the amount of debt exceeds the value of the company, it’s insolvent, as suggested below. What the following doodles illustrate is that for every level of riskiness and volatility, there’s an appropriate limit on leverage in the capital structure.

© Oaktree Capital Management, L.P. All Rights Reserved Now credit and consumer confidence are ebbing, to the likely detriment of company profits. State intervention, which free marketers have argued against for centuries, has been royally legitimized. Paul Volcker put it this way in the FT of April 12: “The bright new financial system – for all its talented participants, for all its rich rewards – has failed the test of the marketplace.” Belief in free market omniscience has been laid to rest for a while. The New York Times of April 15 described Bob Steel, Treasury Under Secretary for Domestic Finance, as being highly optimistic about a “superregulator” or “market stability regulator” that “would pass judgment on the capital levels, trading exposure and leverage of Wall Street’s most sophisticated institutions.” Yet within just the last two years, it says, “Mr. Steel has been co- chairman of one commission that claimed heavy-handed regulation was stanching financial innovation and another that argued that hedge funds could police themselves.” Times certainly do change. And in a sign of the times, breakingviews.com, an online interpreter of financial news, put it this way on May 14: The hands-off approach to financial markets now looks neglectful. . . . Greenspan’s laissez-faire attitude to asset prices went along with paying little attention to bank supervision and positively welcoming the growth of less regulated financial institutions.

© Oaktree Capital Management, L.P. All Rights Reserved During the first leveraged buyout boom in the late 1970s and the 1980s, it was a watchword that they should be done only with stable companies. But in bullish times, rules like that are forgotten or ignored, and we get buyouts of companies in cyclical industries like semiconductors or autos. Extremely leveraged companies have existed for more than a century. They’re called utilities. Because their profits are regulated by public commissions and fixed as a percentage of their stable asset bases, they’ve been extremely dependable. This shows that high leverage isn’t necessarily risky, just the wrong level of leverage given the company’s stability. It can be safe for life insurance companies to take risk on limited capital, because their operations are steady and their risks can be anticipated. They know everyone will die, and roughly when (on average). But if a firm like MBIA was going to guarantee mortgage securities, it should have recognized their instability and unpredictability and limited its leverage. The insurance industry’s way of saying that is that its capital should have been higher as a percentage of the risks assumed. MBIA insured $75 billion of residential and commercial mortgage paper on the basis of total capital – not capital devoted to its insuring mortgage securities, but total capital – of only $3 billion. Did anyone worry about the possibility that 5% of the mortgages would default?

Leverage is always seductive. If you have $1 million of capital and write $25 million of insurance at a 1% annual premium, you bring in $250,000 of premiums, for a 25% return on capital (before losses and expenses). But why not write $50 million of insurance and bring in $500,000? The answer is that policy losses might exceed 2% of the insurance written, in which case your losses would be greater than the capital you have to pay them with . . . and you might be insolvent. But in order to resist using maximum available leverage, you need discipline and an appreciation for the risks involved. In recent years, few firms had both. U Why Mortgages? Why is it residential mortgage-related paper that set off the process endangering our institutions? Why not high yield bonds or leveraged loans or even equities? One reason, of course, is the sheer size of the residential mortgage-related securities market: $11 trillion. But there are two others. The first is the inability to value the underlying collateral. I feel comfortable when Oaktree’s analysts value the debt or equity of a cash-flow-producing company. To the extent an asset produces a stream of cash flows, and assuming they’re somewhat predictable, the asset can reasonably be valued. But assets that don’t produce cash flows can’t be valued as readily (this has been a regular theme of mine of late). What’s a barrel of oil worth? $33 in January 2004, $147 in mid-2008, or $42 earlier this month? Which price was “right”?

Certainly there’s every reason to believe that:  Assets are being valued based on what people will pay for them (which is the goal), but with few people in a buying mood, market prices can far understate value.  Supply and demand have completely supplanted fundamentals in determining prices.  With little trading taking place, assets are often priced via reference to indices. But those indices fluctuate wildly in connection with speculation and hedging activity, and they may have little relevance to the individual asset being priced.  Lenders are switching their valuations of collateral from going concern basis to liquidation basis.  Margin calls are resulting in liquidations, which depress prices, leading to more margin calls. It’s hard to believe these are really the bases on which financial institutions should value their trillion-dollar balance sheets. But we’re stuck for now with mark-to- market accounting. At minimum, you should expect it to contribute extensively to continued volatility. Believe me, it already has. “Should” ≠ “Will” Lately I’ve enjoyed comparisons of recent developments to Frankenstein’s loss of control over his monster, or to a man-made mutation that has escaped from the laboratory. Extensive financial sector experimentation took place involving unprecedented combinations of volatile elements such as leverage, securitization, tranching, derivatives © OAKTREE CAPITAL MANAGEMENT, L.P. ALL RIGHTS RESERVED.

© Oaktree Capital Management, L.P. All Rights Reserved Even understanding Lehman’s current trading positions was tough. Lehman’s roster of interest-rate swaps (a type of derivative investment) ran about two million strong . . . What kind of effort would it require to understand the significance of two million derivatives positions: are they thoroughly hedged, or bullish or bearish on balance? And what about Lehman’s millions of other derivatives and complex securities? This opacity, combined with heavy leverage, reliance on short-term funds, liquidity and conscious risk taking, is the reason why a loss of confidence is conceivable at any financial institution in times of panic. What will the Wall Street of the future look like? We read – and I don’t doubt – that for at least a while it will be smaller, less leveraged, less profitable, and more highly regulated. But I also think it will be less competitive and less risky. In the course of my career, Wall Street went from being (1) brokers handling riskless trades for commission to (2) dealers buying and selling inventory for a spread to (3) block traders purchasing large amounts of stock when market liquidity was inadequate to (4) proprietary traders risking their own capital in pursuit of profit for the house. Backing down this progression wouldn’t be the worst thing in the world. U What Will Start the Recovery? Eventually, someone will walk out of the crowd and take advantage of the lows.

and mark-to-market accounting. In the lab, experimental microbes would be quarantined until their dangers were fully understood. In the financial markets of this decade, on the other hand, they were rapidly popularized and peddled world-wide. In 1998, Long-Term Capital Management became the poster child for the ability of sophisticated investment strategies to malfunction with grave consequences. This hedge fund invested in a highly diverse portfolio of fixed income arbitrage positions. These were situations where two related assets were trading in violation of their normal price relationship: one was a little more expensive relative to the other than history said it should be. LTCM bought into these small mispricings in large quantities, on enormous leverage, in the expectation that they would correct. The explanation for its subsequent meltdown was simple, according to the founder, John Meriwether: “The Fund added to its positions in anticipation of convergence, yet . . . the trades diverged dramatically.” For years these memos have quoted my good friend, Bruce Newberg, as saying, “Improbable things happen all the time, and things that are supposed to happen often fail to do so.” Acting in excessive reliance on the fact that something “should happen” can kill you when it doesn’t. That’s why I always remind people about the 6- foot-tall man who drowned crossing the stream that was 5 feet deep on average. You have to be able to get through the low points.

But such an appraisal obviously says nothing about what a house will bring after being repossessed a few years later. Nevertheless, in recent years, a purchase price of $X, supported by an appraisal of $X, was used to justify lending 95% of $X – or maybe 100% or 105% – when a home was bought or refinanced. No wonder homes valued in the biggest boom in history have turned out to be unreliable collateral. Second, these overrated mortgages were packaged into the most alchemical and fantastic leveraged structures. It is these, not mortgages themselves, that have jeopardized our institutions. There was a limited market for whole mortgage loans; they were considered a specialist market entailing risk and requiring expertise. But supposedly those worries would be obviated if one bought the debt of structured entities that invested in residential mortgage-backed securities (RMBS). First question: where did the risk go? We were told it disappeared thanks to the magic of structuring, tranching and diversifying, permitting vast amounts of leverage to be applied safely. Second question: how reliable was the diversification? Answer: again we were told, highly reliable; there had never been a national decline in home prices, so mortgages could be considered uncorrelated with each other. The performance of a mortgage on a house in Detroit would be unaffected by what went on in Florida or California. (Well, so much for what we were told.)

Just as leverage and willingness to bear risk were the twin engines of the recent boom, so their reduction is likely to cause things to slow. Third, business expansion is unlikely to contribute to growth. Already-slow holiday spending, employment growth and orders for durables are unlikely to encourage businesses to expand production, build inventories or create jobs. The announcement of corporations’ fourth quarter results in a month or so will give us a hint regarding direction. The main offset to concern about a slowdown comes from overseas. In the past, a recession in the U.S. was sure to have effects worldwide. Now, it seems possible that developing economies such as those of China and India will see enough demand from elsewhere – including domestic demand – to avoid importing our slowdown. The most optimistic case holds that foreign demand might avert a recession in the U.S. Such demand could be buttressed by the softness of the dollar, which makes our goods very attractive to buyers spending foreign currencies. We’ll see. As usual, there are optimists and pessimists. The optimists see enough strength to offset the effect of the mortgage losses. The pessimists think a massive contraction in the prices of assets – mostly homes – implies a calamitous contraction that can only be averted through massive government action (if at all). We won’t bet on which is right, but we believe the economy – and thus business – will be less vibrant in the period ahead than it has been.

© Oaktree Capital Management, L.P. All Rights Reserved led to the use of unwise amounts of leverage. But interestingly, the key losses aren’t in the riskier junior tranches of CDO debt, about which there was some leeriness. Rather, they’re in the triple-A-rated tranches. It’s to buy those tranches that our leading institutions took on too much leverage. Once again, greatly underestimated risk led to great leverage and thus great losses. What did you need to steer clear of CDO debt? Computers, sophisticated programs and exceptional analysis? Genius? No: skepticism and common sense. In RMBS, CDOs and CDO-squareds (entities that borrowed to buy CDO debt), 90% or so of their capital structure was rated higher than the underlying collateral, all based on the linchpin assumption that mortgages were uncorrelated. That’s all you had to know. How good a piece of collateral is a subprime mortgage covering 100% of the purchase price of a house bought in a soaring market by an applicant who’ll pay a higher interest rate to be able to skip documenting income or employment? That’s not a secured loan; it’s an option on future appreciation. If the house goes up in price, the buyer makes the mortgage payments and continues to own it. If it goes down, the buyer walks away, in which case the lender gains ownership of a house worth less than the amount loaned against it. Thus the viability of the mortgages was entirely dependent on continued home price appreciation.

Its long positions in AAA mortgage paper should have continued to hold up better than its subprime shorts. But the AAAs declined this year, and they’d bought enough on leverage to make the fund melt down in February.  Credit default swaps should serve as a great way to transfer credit risk. But the market grew out of control – to $40-odd trillion of insurance coverage on $6 trillion © OAKTREE CAPITAL MANAGEMENT, L.P. ALL RIGHTS RESERVED.

Given the above, what was the credit quality of subprime mortgages? I’d say double-B at best. (I’d much rather buy even the single-B “junk bonds” of profitable companies that we’ve held over the last 30 years than this inflated “home option” paper.) And yet, in a typical CDO, 80% of the debt was rated triple-A and 97% was rated investment grade (triple-B or better). Those high ratings made CDO debt very attractive to financial institutions that were able to borrow cheaply to buy high-rated assets, satisfying the strict rules regarding the “quality” of their portfolio holdings. Financial engineers and investment bankers took unreliable collateral and packaged it into highly leveraged structures supporting debt that was rated high enough to attract financial institutions. What a superb example of the imprudent use of leverage. And what a simple explanation of how our highly leveraged institutions got into trouble. UHow Bad is Bad? One of the prime lessons that must be learned from this experience is that in determining how much leverage to put on, you’d better make generous assumptions about how risky your assets might turn out to be. The example in the paragraph on page one demonstrates the role of risk in the equation. The more your assets are prone to permanent loss, the less leverage you should employ. But it’s also important to recognize the role of volatility.the

of debt – and no one knows just how it’ll all work out. When CDS are traded around, the people who bought coverage have no way of knowing if their insurers’ capital is adequate. Thus, efforts to off-load credit risk may have replaced it with “counterparty risk.” Clearly, investors only make investments because they expect them to work out, and their analysis will center on the likely scenarios. But they mustn’t fixate on that which is supposed to happen to the exclusion of the other possibilities . . . and load up on risk and leverage to the point where negative outcomes will do them in. At the same time, however, it’s very hard to figure out how broad the range of considered possibilities should be. No investment action can withstand every possible development. Is there really such a thing as a “worst case assumption” short of a total loss? I often find myself asking one of the classic questions in investing: How much effort and capital should we devote to preparing for the improbable disaster? Many of the recent problems occurred because investors expected outcomes other than the ones that arose. Had they been too optimistic? Or did the environment simply throw curves that no one should have been expected to handle? Leverage and Risk Two important investment principles should be embraced concerning leverage and risk: First, leverage magnifies outcomes but doesn’t add value. I’ve said that so often that I ought to stop.

© Oaktree Capital Management, L.P. All Rights Reserved lenders can cut off credit, (b) investors can be frightened into withdrawing their equity, or (c) the violation of regulatory or contractual standards can trigger forced selling. The problem is that extreme volatility and loss surface only infrequently. And as time passes without that happening, it appears more and more likely that it’ll never happen – that assumptions regarding risk were too conservative. Thus it becomes tempting to relax rules and increase leverage. And often this is done just before the risk finally rears its head. As Nassim Nicholas Taleb wrote in Fooled by Randomness: Reality is far more vicious than Russian roulette. First, it delivers the fatal bullet rather infrequently, like a revolver that would have hundreds, even thousands of chambers instead of six. After a few dozen tries, one forgets about the existence of a bullet, under a numbing false sense of security . . . Second, unlike a well-defined precise game like Russian roulette, where the risks are visible to anyone capable of multiplying and dividing by six, one does not observe the barrel of reality. . . . One is thus capable of unwittingly playing Russian roulette – and calling it by some alter- native “low risk” name. (p. 28; emphasis added) The financial institutions played a high-risk game thinking it was a low-risk game, all because their assumptions on losses and volatility were too low.

But just a few reminders:  Leverage magnifies losses as well as gains. In Las Vegas, they say, “The more you bet, the more you win when you win.” But they always forget to add “. . . and the more you lose when you lose.” Leverage is just a way to bet more.  Leverage magnifies outcomes but doesn’t add value. It will make for higher highs and lower lows, and it might even produce an increase in the expected value . . . assuming outcomes are normal. But it can’t make something a fundamentally better investment. Thus, leverage absolutely cannot be equated to the contribution to return that comes from skill in selecting investments or in restructuring company operations or finances.  From time to time, people come up with structures that are purported to add to an investment’s upside without adding proportionally to its downside. They rarely work. Or, expressed properly, it makes no sense to expect them to enhance the expected return without increasing the range of outcomes and the risk of loss. You may be able to take an investment with a 10% promised return and turn it into a vehicle that has a 90% chance of earning 13% and a 10% chance of losing everything. But can © OAKTREE CAPITAL MANAGEMENT, L.P. ALL RIGHTS RESERVED.

you end up with something that has a higher expected return but isn’t riskier? That’s too good to be true.  Finally, in addition to magnifying losses as well as gains, leverage carries an extra risk on the downside that isn’t offset by accompanying upside: the risk of ruin. Leverage, when added to losses, can lead to margin calls and meltdowns. There is no corresponding benefit. This lesson is being well learned today. Second, every investment or portfolio entails a variety of risks, and its overall risk is the sum of those. Every investment embodies both the specific risk related to the individual company or asset and the systematic risk that is a function of its membership in a market – its beta. There also can be liquidity risk, legal risk, currency risk and political risk. Finally, risk is introduced by the structure in which an asset is held. Here I’m referring to the risk that comes with leverage. To simplify for my current purpose, risk comes from the combination of what you buy and how you finance it. You can buy very risky assets, but if you don’t lever up to do so, you’ll never lose them to a margin call. Or you can buy fundamentally safe assets, but the combination of enough leverage and a sufficiently hostile environment can cause a meltdown. In other words, investing in “safe” assets isn’t necessarily safe, particularly if you’ve borrowed to buy them. We’ve seen this at work in recent days, as entities that invested in top-quality assets have run into trouble.

In the distressed debt funds that we organized in 1990 and 2002, both times of chaos in financial markets, we earned net IRRs in the 30s and 40s. If you think about it, those IRRs have to be described as aberrant. No one should be able to earn returns like those without significant leverage. And yet we did. Like all active investors, we try to buy things for less than they’re worth. The above results suggest we were aided in those funds by people who were willing to sell things far below their worth. Why would they do so? Often because of the fire sale process described above. Not surprisingly, our financial leaders are attempting to short-circuit this process. Mortgage defaults are real and widespread and will produce losses for holders of related securities. Eventually those losses will have to be recognized and dealt with. But I think several of the actions we’re seeing are aimed at avoiding exaggerated, panicked fire sales:  injections of liquidity,  mortgage reset holiday,  taking SIVs (and their debt) onto balance sheets, and  proposing a Super-SIV (which now seems to be history).

© Oaktree Capital Management, L.P. All Rights Reserved Consider these tales from the front lines:  There had never been a national decline in home prices, but now the Case-Shiller index is down 26% from its peak in July 2006, according to the Financial Times of November 29.  In my twenty-nine previous years with high yield bonds, including four when more than 10% of all outstanding bonds defaulted, the index’s worst yearly decline was 7%. But in 2008, it’s down 30% (even though the last-twelve-months’ default rate is only about 3%).  Performing bank loans never traded much below par in the past, and holders received very substantial recoveries on any that defaulted. Now, even though there have been few defaults, the price of the average loan is in the 60s. The headlines are full of entities that have seen massive losses, and perhaps meltdowns, because they bought assets using leverage. Going back to the diagrams on pages 4-5, these investors put on leverage that might have been appropriate with moderate-volatility assets and ran into the greatest volatility ever seen. It’s easy to say they made a mistake. But is it reasonable to expect them to have girded for unique events? If every portfolio was required to be able to withstand declines on the scale we’ve witnessed this year, it’s possible no leverage would ever be used. Is that a reasonable reaction? (In fact, it’s possible that no one would ever invest in these asset classes, even on an unlevered basis.)

For example, Carlyle Capital Corp. (“CCC”) invested in AAA-rated debt of the two government-sponsored housing agencies, Freddie Mac and Fannie Mae. But it levered its equity 31 times to do so, buying $21.7 billion of securities on the basis of just $670 million of equity. That meant that if values declined 3%, its equity would be gone. Worried bankers pulled back their loans; CCC received margin calls it couldn’t meet; the banks seized its assets; and the fund melted down. Investment safety doesn’t come from doing safe things, but from doing things safely. Put another way, anything can be screwed up by using so much leverage that its fluctuations can’t be survived. That’s why, in writing about LTCM in “Genius Isn’t Enough” (January 1999), I said leverage + volatility = dynamite. Financial Self-Destruction The dramatic cyclical up leg of nearly five years (I’d say November 2002 through June 2007), as well as the far shorter but equally dramatic down leg that started last summer, have given me opportunity to reflect on a number of phenomena to be noted and lessons to be learned. You’ve seen the results in the last three memos (“No Different This Time,” “Now What?” and “Whodunit”). I’ve reached a new view of how some things work, based on tying together several separate observations. © OAKTREE CAPITAL MANAGEMENT, L.P. ALL RIGHTS RESERVED.

© Oaktree Capital Management, L.P. All Rights Reserved Even if we realize that unusual, unlikely things can happen, in order to act we make reasoned decisions and knowingly accept that risk when well paid to do so. Once in a while, a “black swan” will materialize. But if in the future we always said, “We can’t do such-and-such, because we could see a repeat of 2007-08,” we’d be frozen in inaction. So in most things, you can’t prepare for the worst case. It should suffice to be prepared for once-in-a-generation events. But a generation isn’t forever, and there will be times when that standard is exceeded. What do you do about that? I’ve mused in the past about how much one should devote to preparing for the unlikely disaster. Among other things, the events of 2007-08 prove there’s no easy answer. UAre You Tall Enough to Use Leverage? Clearly it’s difficult to always use the right amount of leverage, because it’s difficult to be sure you’re allowing sufficiently for risk. Leverage should only be used on the basis of demonstrably cautious assumptions. And it should be noted that if you’re doing something novel, unproven, risky, volatile or potentially life-threatening, you shouldn’t seek to maximize returns. Instead, err on the side of caution. The key to survival lies in what Warren Buffett constantly harps on: margin of safety. Using 100% of the leverage one’s assets might justify is often incompatible with assuring survival when adverse outcomes materialize.

© Oaktree Capital Management, L.P. All Rights Reserved Finally, a statement by the Chief Executive of UBS provided another insight into the recent events. Early last December, he said, “the ultimate value of our subprime holdings . . . remains unknowable.” I admire his candor, and I’m sure he’s right. But the question I’m left with is whether it might have been possible for buyers of subprime-related paper to reach that realization at the time they first evaluated those assets? U Where Does the Buck Stop? In affixing ultimate responsibility for losing investments, I tend to look to the investors who made them. Sometimes investors are blind-sided by unforeseeable events, and sometimes they’re preyed upon by unethical or even criminal purveyors. But usually the process couldn’t have gone as far as it did if it wasn’t for buyers who sought return too avidly, trusted too much, failed in some way to be alert to the potential for loss, and fell for something that was too good to be true. Everyone dreams of return without high risk. But where can it be found? Not in markets that are working properly – that is, markets that are efficient. Not in leverage, which should be expected to cut both ways, magnifying both risk as well as return. Not in doing what everyone else is doing, or in buying the product du jour that’s being touted broadly and purchased unquestioningly.

Leverage is neither good nor bad in and of itself. In the right amount, applied to the right assets, it’s good. When used to excess given the underlying assets, it’s bad. It doesn’t add value; it merely magnifies both good and bad outcomes. So leverage shouldn’t be treated as a silver bullet or magic solution. It’s a tool that can be used wisely or unwisely. Our attitude at Oaktree is that it can be wise to use leverage to take advantage of high offered returns and excessive risk premiums, but it’s unwise to use it to try to turn low offered returns into high ones, as was done often in 2003-07. Once leverage is combined with risky or volatile assets, it can lead to unbearable losses. Thus leverage should be used in prudent amounts, to finance the right assets, and with a great deal of respect. And it’s better used in the trough of the cycle than after a long run of appreciation. Bottom line: handle with care. * * * I never want to give the impression that doing the things I discuss is easy, or that Oaktree always gets it right. This memo calls on investors to gauge risk and use only appropriate leverage.for

© Oaktree Capital Management, L.P. All Rights Reserved drowned crossing the stream that was five feet deep on average. Investors have to make it through the low points. This statement makes obvious sense. Certainly investors must brace for untoward developments. There are lots of forms of financial activity that reasonably can be expected to work on average, but they might give you one bad day on which you melt down because of a precarious structure or excess leverage. But is it really that simple? It’s easy to say you should prepare for bad days. But how bad? What’s the worst case, and must you be equipped to meet it every day? Like everything else in investing, this isn’t a matter of black and white. The amount of risk you’ll bear is a function of the extent to which you choose to pursue return. The amount of safety you build into your portfolio should be based on how much potential return you’re willing to forgo. There’s no right answer, just trade-offs. That’s why I went on from the above as follows: Because ensuring the ability to [survive] under adverse circumstances is incompatible with maximizing returns in the good times, investors must choose between the two. One of the most interesting questions I’ve pondered over the years is this: How much should we spend – be it in the form of insurance premiums or forgone returns – to protect against the “improbable disaster” (my term for the black swan)? But that’s all it remains: a question.

The naked swimming which is encouraged by the rising tide certainly is exposed when the tide goes out. But I’d go further: in the dynamic environment of the marketplace, naked swimming eventually can cause the tide to go out. A New Kind of Crisis People ask me whether things look familiar, and how this cycle compares to others I’ve experienced. I tell them this one’s different in both degree and kind. We’ve had collapses in the past, but never so broad-gauged and systemic. The earlier ones were the result of things going on in specific sectors or regions: LBO debt in 1990, real estate in 1992-94, emerging markets in 1997-98, and tech/telecom stocks in 2000-02. Most people would prefer to see the weakness centered in specific areas . . . and thus containable, treatable and avoidable. This bust isn’t sector-based, although it was ignited first in subprime mortgages. Instead, it stems from the broad application of the techniques I’ve been discussing: leverage, securitization, tranching and derivatives. Because Wall Street applied those techniques in so many ways, the current problems are generalized and pervasive and have the ability to cause losses in a wide variety of areas, irrespective of the underlying fundamentals. The current bust arose against a backdrop of healthy fundamentals. The economy was growing. Commercial real estate wasn’t overbuilt. Bond defaults were at record lows. Yet huge markdowns have taken place in these areas.

© Oaktree Capital Management, L.P. All Rights Reserved error. But history isn’t a perfect guide. While we’ve made no use of leverage in the vast majority of our investment activities, three of our evergreen funds did borrow to buy bank loans: the senior-most debt of companies, which in the past always has traded around par. Another used it to buy low-priced Japanese small-cap stocks. The companies generally are doing fine, but the prices of their loans and equities have collapsed under current market conditions, causing the funds to suffer. This shows how tough it is to prepare for all eventualities . . . in other words, to know in advance how bad is bad. So I apologize if I ever come across as holier-than-thou. We’ve tried to use leverage only when it’s wise, but no one’s perfect. Certainly not us. * * * The financial markets have delivered a lifetime of lessons in just the last five years. Some of the most important ones center around the use and abuse of leverage.  Leverage doesn’t add value or make an investment better. Like everything else in the investment world other than pure skill, leverage is a two-edged sword – in fact, probably the ultimate two-edged sword. It helps when you’re right and hurts when you’re wrong.  The riskier the underlying assets, the less leverage should be used to buy them. Conservative assumptions on this subject will keep you from maximizing gains but possibly save your financial life in bad times.

First, with a slower economy, there’s every reason to believe creditworthiness will decline and defaults will rise. It’s just hard to believe that the incidence of default will be unaffected if the economic environment turns less salutary. Second, over the last few years we’ve seen a highly elevated level of buyout activity, with deals priced at increasing multiples of cash flow and financed with rising proportions of debt. Better companies can support higher debt levels, and some of the buyouts have been of top companies. But we feel that prices and leverage ratios have been high in the absolute, and that competition to buy companies in a heated environment made buyout funds stretch on purchase price. Some of the assumptions underlying these deals undoubtedly will prove to have been overly optimistic, and eventually we’ll have the opportunity to buy debt in those deals at discounts. Non-performing debt related to leveraged buyouts gave us great buying opportunities when the LBOs of the 1980s cratered in 1990. Chastened providers of capital cut back their lending in the 1990s, and thus buyouts didn’t contribute to the 2002 debt crisis. But we expect unsuccessful buyouts to be a primary source of distressed opportunities in the next go-round. Given the high volume of non-investment-grade debt issuance recently, even a moderate rate of default implies a heavy supply of distressed debt, contributing to the perception of a credit meltdown.

First, let’s consider financial institutions and the housing market. In recent years, as everyone knows, the former combined with the latter to create a bubble based on the combination of leverage, innovative structuring and heedless buying. Institutions and housing have been gravely hurt, and they’re likely to bring harm to additional sectors of the economy. For their downward spiral to be arrested, I see four things that have to happen:  Home prices have to stop going down.  Home mortgages have to be made available.  Financial institutions have to stop experiencing incremental write-offs.  Financial institutions have to be able to raise additional capital with which to rebuild their balance sheets. The problem I see is that each of these four things is dependent on the occurrence of another – a classic chicken-or-the-egg problem. Write-offs won’t stop until home prices stop going down. Prices won’t stop going down until mortgages become available. Mortgages won’t become available until lenders can raise capital. And capital won’t be freely available until write-offs stop coming. Which will happen first, facilitating the others? What will cause it to happen? When? These things will happen, of course. Maybe for reasons we can’t foresee. Maybe for no apparent reason. And maybe just because things got so bad they couldn’t get any worse. I go through this only to show why I don’t see an easy or quick solution. But then I’m rarely an unbridled optimist.

 A levered entity can be caught up in a downward spiral of asset price declines, market-value tests, margin calls and forced selling. Thus, in addition to thinking about the right amount of leverage, it’s important to note that there are two different kinds: permanent leverage, with its magnifying effect, and leverage which can be withdrawn, which can introduce collateral tests and the risk of ruin. Both should be considered independently. Leverage achieved with secure capital isn’t nearly as risky as situations where you are subject to margin calls or can’t bar the door against capital withdrawals. Leverage was too easily accessed as recently as two years ago, and now it’s virtually unavailable. And just as its use was often unwise a few years ago, this might be just the right time to employ some if you can get it . . . and if you can arrange things so you won’t drown if the streambed dips ahead.2008

© Oaktree Capital Management, L.P. All Rights Reserved part of CDO managers. I imagine they relied heavily on the participation of the rating agencies and monoline insurers. Each of these was flawed. What made them believe that mortgage loans could be bought up and packaged into CDO securities (with multiple fees paid along the way) with the resulting return still excessive? Why should one legitimate double-A significantly out-yield another? Why didn’t they ask more about the process through which this miracle was being accomplished? Why did they accept that narrow spreads could safely be turned into generous returns through leverage? Why did they trust so heavily in the simulated performance of securities for which the existing track record wasn’t applicable? Did they look into the motivation and capabilities of the rating agencies and insurers on which they depended? In short, were they skeptical enough? Many CDO buyers had no independent ability to assess the risks of CDOs. But they bought anyway. They followed their desire for high risk-adjusted returns, took action based on the relationship between promised return and rating, and went astray. The bottom line of all of this is that one of the main functions of markets is to drive out excess return by bringing buyers and sellers together at prices from which the return will be just fair. Realizing that makes skepticism an indispensable ingredient in superior investing.

© Oaktree Capital Management, L.P. All Rights Reserved bank lending, weaker loan standards and rising risk tolerance. The risk embodied in these things came home to roost in residential mortgages first because it’s there that they were applied to the greatest extent and to the weakest underlying collateral. Too many triple-A securities were created from each pool of non-investment grade mortgages, and they collapsed as soon as default rates surpassed the models’ assumptions.  The credit crunch was an obvious next step. A number of more generalized developments resulted from the mess in residential mortgages: o rising risk aversion, o higher demanded risk premiums, and thus lower prices for risky assets, o the withdrawal of leverage and liquidity, o leveraged fund meltdowns and frightening headlines, o losses at banks and thus endangerment of their capital adequacy, and o hoarding of capital and the unavailability of new loans.  This resulted in problems at financial institutions. Losses on highly leveraged investments were sure to lead to a crisis mentality, which could morph easily into a plain old crisis. What are the characteristics of financial institutions? o high leverage, o near-total reliance on short-term deposits and borrowings to fund illiquid, longer- term assets, o risk bearing – that’s what their business consists of, and it’s by doing so that they earn lending spreads (if they borrowed safe and lent safe, where would the spread come from?)

Regulation is destined to increase, and in exchange for its support of financial institutions, the Federal government is likely to demand that they carry less leverage and take less risk. Thus financing could be scarce. But positives do exist. Dollar-denominated exports look very cheap to the rest of the world and will bolster the U.S. economy. And the Fed will do everything possible to help (but it can reduce rates only so far and has to remain vigilant regarding inflation). The usual tug-of-war is taking place between the optimists and the pessimists. On July 18, the Financial Times quoted Deutsche Bank chief executive, Josef Ackermann, as saying, “We are seeing the beginning of the end of the crisis.” But the very next day, The New York Times quoted Alan Blinder (ex-vice chairman of the Fed board of governors): “The financial system looks substantially worse now than it did a month ago.” On balance, I continue to think the odds favor economic sluggishness for a not- insubstantial period of time. Given today’s general dearth of beaten-down assets outside of residential real estate and financial institutions, investing gradually probably won’t cause you to miss great opportunities. But it will keep you out of trouble and ensure that you have capital with which to take advantage of any bargains ahead. In my book, going slow here makes the most sense.2008

© Oaktree Capital Management, L.P. All Rights Reserved Finally, underperforming companies will crop up in private equity portfolios, and the need for turnarounds and restructurings will take up time and pull down returns. In many ways, the private equity industry may have to operate as it did in an earlier era, when funds were smaller, the volume of transactions was more moderate, both purchase and sale prices were lower, holding periods were longer, and IRRs were lower (but perhaps more meaningful in terms of times-capital-returned). Funds will have to make money the way they used to, with more emphasis on buying cheap and adding value and less on financial engineering and quick flips. Large funds formed within the last 12-18 months may find themselves uninvested for a while, and thus in high-fee limbo. * * * It’s worth remembering that the boom of the last few years arose in the financial sector, not the “real world.” Economies grew around the world – as did corporate profits – but there was no economic boom other than in developing nations. It was optimism, risk tolerance, innovation, liquidity, leverage, credulity and the race to compete that reached multi-generational highs. Thus the ramifications will be (actually, have been) felt first and most strongly in the financial sector. The question is how far they’ll spread from there. Undoubtedly, credit will be harder to obtain.

There’s been lots of bad news and writeoffs. More and more people recognize the dangers inherent in things like innovation, leverage, derivatives, counterparty risk and mark-to-market accounting. And increasingly the problems seem insolvable. One of these days, though, we’ll reach the third stage, and the herd will give up on there being a solution. And unless the financial world really does end, we’re likely to encounter the investment opportunities of a lifetime. Major bottoms occur when everyone forgets that the tide also comes in. Those are the times we live for. March 18, 2008 © OAKTREE CAPITAL MANAGEMENT, L.P. ALL RIGHTS RESERVED.

© Oaktree Capital Management, L.P. All Rights Reserved As I noted a few years ago, (see “Risk and Return Today,” October 2004) we were living in a low-return world. The prospective returns offered on traditionally safe investments were low in the absolute. Moving out on the risk curve added little to expected returns; i.e., risk premiums were in many cases at record lows. Overall, then, the Capital Market Line – the risk/return curve – was “low and flat.” In all, the rewards offered for risk bearing were paltry. So what was an investor to do in that low-return world? You could make your usual investments and accept returns below those you’re used to, perhaps deciding to allocate your capital for the long term and ignore the short term. Or you could decline to invest and hold cash instead, despite the fact that the expected return for doing so is invariably the lowest. Or – as I think most people did – you could reject the low returns available on your usual investments and go for more. That is, you could insist on achieving high returns in a low-return world. But insisting on them is one thing, and positioning your portfolio to get them is another. How might the latter be accomplished? The answer is simple: many reached for return. Primarily that meant making riskier investments or using leverage to increase the capital at risk (or both). That’s the main story of the last few years, and the reason behind the jam the markets are in today. USo What Happened?

As I wrote in “Risk and Return Today,” in recent years investors did things they’d never done before – or hadn’t done as much of – because they wanted more than the 4-5% they could get in high grade bonds and the 6-7% they felt they could expect from U.S. equities. They put more into hedge funds, for example, and their commitments expanded the largest buyout funds from $3-5 billion to $20 billion-plus in just a year or two. Investors succumbed to the siren song of leverage. They borrowed cheap short-term funds – the shorter the cheaper (you can get money cheap if you’re willing to pledge assets and promise repayment monthly). And they used that money to buy assets that offered higher returns because they entailed illiquidity and/or fundamental risk. And institutional investors all over the world took Wall Street up on the newest promises of two “silver bullets” that would provide high returns with low risk: securitization and structure. On the surface, these investments made sense. They promised satisfactory absolute returns, as the returns on the leveraged purchases would more than pay the cost of capital. The results would be great . . . as long as nothing untoward happened. But, as usual, the pursuit of profit led to mistakes. The expected returns looked good, but the range of possible outcomes included some very nasty ones.many

Our active distressed debt funds gained 20% that month, and the markets never looked back. Investors in all asset classes forgot the panic that had gripped them just a few months earlier and became preoccupied with making money. Because only modest returns were expected from high grade bonds (with their 4-5% yields) and U.S. common stocks (following the 2000-02 bear market), investors sought solutions in non-traditional investments with brief track records at best, and thus little or no clarity regarding the risks involved. Vast sums flowed to hedge funds, and thousands of new ones were formed. High yield bonds and leveraged loans began to be issued again . . . because now there were buyers. This enabled buyouts to be financed and then recapitalized, and quick payouts to equity holders resulted in eye-popping IRRs, attracting more capital to buyout funds. Real estate attracted vast amounts of capital, too, even when “cap rates” – current cash yields – sunk below 5%; what could be better than a tangible asset providing inflation protection? Borrowing power became virtually unlimited, as is often the case when providers of capital are eager to put money to work. Thus the financial environment reflected (1) a vast ability to leverage, (2) an uninhibited search for return, and (3) investors competing to make investments by accepting lower returns and decreased safety. This combination supported new investment techniques, which grew rapidly despite being untested.

© Oaktree Capital Management, L.P. All Rights Reserved UUnusual Breadth In the past we’ve seen bull markets in equities, commodities and real estate. And we’ve seen bull markets in the U.S., Japan and the emerging markets. But this time around, we’ve been seeing a near-global bull market, where the participating sectors vastly outnumber those left out. In his April letter to investors, entitled “The First Truly Global Bubble,” Jeremy Grantham summed up the worldwide nature of the good times. Never before have UallU emerging countries outperformed the U.S. in GDP growth over a 12-month period until now, and this when the U.S. has been doing well. Not a single country anywhere – emerging or developed – out of the 42 listed by The Economist grew its GDP by less than Switzerland’s 2.2%! Amazingly uniform strength, and yet another sign of how globalized and correlated fundamentals have become, as well as the financial markets that reflect them. Bubbles, of course, are based on human behavior, and the mechanism is surprisingly simple: perfect conditions create very strong “animal spirits,” reflected statistically in a low risk premium. Widely available cheap credit offers investors the opportunity to act on their optimism. Sustained strong fundamentals and sustained easy credit go one better; they allow for continued reinforcement: the more leverage you take, the better you do; the better you do, the more leverage you take.

© Oaktree Capital Management, L.P. All Rights Reserved before. Collateralized loan obligations and collateralized debt obligations, for example, grew practically unchecked. These debt factories bought up vast amounts of raw material – in the form of underlying portfolio assets – in order to generate a salable product. The bottom line of it all: high leverage, untested vehicles and inadequate preparedness for adverse developments. Little awareness of risk, low credit standards, slender risk premiums and little margin for error. In short, a recipe for possible disaster. UThe Vicious Circle It’s easy to explain what happens at this point in the typical market cycle: eventually, everything goes the other way. That’s exactly what happened this summer. There’s a bump in the road. It doesn’t matter what it is, and it’s usually different each time. This year the problem occurred in the field of subprime mortgages. There was a surprising rise in delinquencies, the immediate effect of which was limited to a small segment of the economy and the few investors who’d bought securities backed by these loans. In the months leading up to July, the impact went largely undetected outside the subprime arena. But from time to time in the investment world, a chain reaction is set off – maybe you’d say a “tipping point” is reached – which causes one sort of problem to create others and to cascade from one asset class, market or region to others.

© Oaktree Capital Management, L.P. All Rights Reserved  If portfolio holdings have to be sold to reduce leverage or raise cash to meet actual or feared withdrawals, this has a depressant effect on asset prices that reinforces the cycle.  Lower asset prices may lead to margin calls, and thus possibly to fire sales.  Forced sellers sell what they can sell, not necessarily what they want to sell. As a result, the prices of assets that are entirely unrelated to the fundamental problem can join the downward spiral. It’s for this reason that they say, “In times of crisis, all correlations go to one.” Every one of the above factors has been seen in the last few weeks – all growing from just the subprime seed. The economy is still showing good strength overall and most companies are doing fine; the default rate among high yield bonds continues to run at 25-year lows. But strong fundamentals mean little if technical factors combine with a fundamental problem to profoundly depress investor psychology. It’s important to remember the extent to which these factors interrelate. Fundamentals influence psychology, which determines technicals, which feed back to further affect fundamentals. Just as these things can create a virtuous circle on the upside – such as the one that has prevailed since late-2002 – they’re now behind the apparent start of a vicious circle on the downside.

© Oaktree Capital Management, L.P. All Rights Reserved  Suddenly, market participants realized how hard it can be to value obscure, infrequently-traded assets and how much the prices of such assets can diverge from their value. In fact, “value” can be an empty concept in times of crisis, when it becomes painfully clear that an asset is only worth what it can be sold for. Thus people came to question the prices funds were using to value subprime-related holdings, as well as the model-derived prices their investment bank creators had charged for them.  Worried about both subprime fundamentals and pricing, and suddenly under increased scrutiny, many lenders stopped providing financing. Short-term commercial paper, which many investors had used to leverage their subprime-related asset investments, became largely impossible to roll over.  Funds that had promised liquidity to their investors – even some money market funds – became worried about their ability to accurately value subprime holdings and sell them at fair prices. Thus they suspended withdrawals. What could have a more traumatic effect on investor confidence?  Where leverage was withdrawn, margin calls arrived, or funds had to meet actual or feared withdrawals, holders of subprime assets became forced sellers. Few things have a more devastating effect on investment performance.

” This time around, the answer is “lots of people.” The Magic of Leverage It’s obvious that the key element in many of the errors that tripped up investors this time around was cheap and easy credit, utilized without much awareness of risk. An oversupply of capital looking for a home in non-traditional investments caused vast sums to be pushed into mortgage loans at low-cost teaser rates to un-creditworthy homebuyers who often weren’t required to document their incomes. It let hedge funds bulk up on the carry trade and buyout funds bid enough to acquire world-class companies, taking on enough leverage to target high expected returns. And it was the building block supporting CLOs, CDOs, CDO2s, conduits, SIVs and other highly leveraged entities. The Fed delivered cheap credit for the best of reasons: to counter the depressing effects of the emerging market crisis, 9/11, the tech bubble bust, the first three-year stock market decline since the Depression, Y2K, the telecom meltdown, concern about deflation, and whatever else was on its mind. Interest rates were the lowest most of us had ever seen, anchored by 1% on cash. The low rates both (a) drove down returns on investments at the safe end of the risk curve and (b) provided the fuel for elevated risk taking. One must never forget that leverage doesn’t make investments better; it just magnifies the gains and losses.

UThe L Word Revisited Most explanations of the financial dynamism of the last few years have centered on something called “excess liquidity.” Vast amounts of liquidity in the hands of investors, it’s been said, caused them to avidly pursue investments, neglect due diligence, accept low prospective returns, and therefore bid up asset prices. But where does excess liquidity come from? Not from more currency. The amount of currency in the world is somewhat fixed, and each person’s receipt is another person’s expenditure. The fact that China has massive reserves to invest merely means those sums came out of someone else’s account. I think the “L word” that should be focused on isn’t liquidity, but leverage. This is the one I discussed in “It’s All Good,” and the element behind many of the excesses of late. High levels of lending and borrowing relative to capital balances can increase buying power and fire up economies and markets. The question is whether that expansion will be maintained and increased. If not, this source of growth will peter out . . . as has been the case in the last few weeks. A decade or so back, the ability of parties other than the Fed to increase the leverage in the system was limited. Margin debt for purchases of stock couldn’t exceed 100% of an investor’s equity, and bank loans likewise were restricted to a multiple of capital.

© Oaktree Capital Management, L.P. All Rights Reserved significant overlap – have negated the old limits and made vast amounts of leverage available to investors and asset buyers. This leveraging up was the greatest single element in the asset surge of the last few years. In fact, the breadth of the gains tells me we didn’t have an “asset bubble,” but rather a “leverage bubble.” As Jeremy Grantham points out in his latest letter, leveraged loans (so-called “bank loans” often funded by hedge funds rather than banks) are a good candidate for the “bubble” label, as their volume in the first half of 2007, at $545 billion, was up 60% over the same period in 2006, which showed a similarly dramatic increase over 2005. Leverage (along with the lowered standards that resulted from eagerness to put borrowed capital to work) was the common thread in much of the appreciation that took place across asset classes and regions. Now we’re having a chance to see – once again – that the process works in both directions. And as so often is the case, the air tends to come out of the balloon far faster (and more violently) than it went in. The process is mesmerizing – like watching a train wreck happen. UThe Engine of Growth Seizes Up The pervasiveness of leverage throughout the financial system means the slowing process comes in many forms and takes many twists and turns. It’s not possible – or necessary – to enumerate all of them. All we need are a couple of examples.

© Oaktree Capital Management, L.P. All Rights Reserved  Acceptable debt/equity ratios – and thus the prices funds were willing to pay for companies – increased as the cost of debt financing fell.  Companies became even more leveraged as recapitalizations allowed debt to replace equity on post-acquisition balance sheets. Although purchase prices and leverage ratios were rising rapidly, the banks were ready and willing to “bridge” – or accept the risk involved in completing – future financings for buyouts. Often this came in the form of “staple financing,” through which banks enabled buyers to include committed financing as a component of their bids. As of a month ago, banks had committed to supply $277 billion of financing for buyouts, a figure that omits equity bridges (promises to raise some of the equity required in a buyout) as well as non- U.S. transactions. These bridges have become one of the big stories of 2007. Prior to July, investors competed to put money to work despite rising buyout prices, increasing leverage ratios, declining yield spreads and weaker terms and covenants. The banks counted on this eagerness in extending their financing commitments, and for years they were not disappointed. But then the negative developments in subprime mortgages reminded investors about risk.  The sight of funds melting down and suspending withdrawals was sobering.  Worry about the economic impact of falling home prices and less buoyant consumer spending became pervasive.

Since most investments have a positive expected value, meaning that gains are expected on average, leverage has the effect of appearing to enhance the expected return. And most of the time, that works just fine. But once in a while, something goes awry. Maybe asset prices go so high they become unsupportable. Maybe the analysis behind an investment proves to have been faulty.

© Oaktree Capital Management, L.P. All Rights Reserved Maybe an exogenous event negatively influences asset prices or funding availability or both. And maybe they all happen at once. When the unlikely occurs – when asset prices decline unexpectedly – the impact as magnified by leverage can be unbearable, setting off a negative chain reaction. Falling asset prices cause lenders to shy away from providing credit, and eventually to demand repayment. With credit less available, repayment might have to come from asset sales, putting additional downward pressure on prices in an already unaccommodating market. Prices go down further; confidence worsens; lenders grow more cautious; and credit becomes even less available. What used to be a virtuous circle becomes a vicious circle. This is how credit crunches occur. There is a recurring element in most investor meltdowns. Lured by attractive promised returns or spurred on by the perceived inadequacy of unleveraged returns, investors borrow short-term capital with which to buy long-term assets. And then eventually there comes a bad day, on which the short-term capital flows out (in response to demands for repayment, the maturing of borrowings, or investor withdrawals). And on that particular day, perhaps (a) the outgoing capital can’t be replaced and (b) portfolio assets can’t be sold at fair prices.

For these we’ll take a look at collateralized debt obligations, or CDOs. For a simple example, consider commercial mortgage-backed securities, or CMBS. Over the last few months, Bruce Karsh has pointed out that prices for CMBS were falling even though the business of being a landlord was good and prices of buildings were increasing. His explanation has been that many CDOs held both subprime paper and the riskier tranches of CMBS. Because of the developments in the subprime area, (1) they were affected by psychological contagion, (2) new ones couldn’t be formed, meaning CDOs ceased to be buyers of new CMBS, and (3) some faced the need to reduce their leverage and raise cash. Unable to sell subprime assets (or not wishing to recognize losses if they could be deferred), they’ve been selling CMBS, putting downward pressure on prices. That’s how problems in one asset class can depress prices in another. Now let’s look a little deeper. Bear in mind that CDO managers are paid to (1) issue debt in tranches that vary in terms of seniority and promised return and (2) use the proceeds to assemble portfolios of debt instruments. Borrow and buy, borrow and buy. A CDO manager’s compensation increases in proportion to the amounts involved and is locked in for the term of the CDO.on

© Oaktree Capital Management, L.P. All Rights Reserved  Alt-A mortgages – not subprime, but similarly weak on documentation,  mortgage lenders,  commercial mortgage-backed securities, not because rents or property values are down, but because these securities may be held by residential mortgage investors forced to raise cash,  bridge financings – and with them the likelihood of future buyouts looking anything like those of the recent past,  the investment and commercial banks that committed to the bridges,  the stocks of target companies in announced buyouts that are shaky as to completion and/or likely to be renegotiated,  merger arbitrageurs, or “risk arbs,” who assumed the risk of these deals failing to be consummated as announced,  others who bet that good times and low volatility would continue, and that probable things would happen and improbable things wouldn’t. These include sellers of put options and credit default insurance,  “quant firms” that built highly leveraged portfolios with help from models that extrapolated past market behavior,  hedge funds and other leveraged investors in a wide variety of fields that pursued “spread” or “carry” trades using large amounts of borrowed money (more on this later),  banks (e.g., Germany’s IKB) and fund managers (e.g.

Sales, if feasible, may have to be made at prices so low that, if all the assets were marked there, the entity’s net worth would be negative. That’s it: meltdown. That’s what happened this summer to Bear Stearns’s High-Grade Structured Credit Strategies Enhanced Leveraged Fund. It happened to Long-Term Capital Management in 1998 and to the Granite Fund in 1994. And it’ll happen again – because financial memory is short and the attraction of leverage can be irresistible. Investors must remember that it’s not enough that an investment has a good expected return, or that the negative outcomes are unlikely. One of the overlooked effects of leverage is that it “fattens the tails” – increases the likelihood of extreme outcomes in both directions – and worsens the consequences of negative events. Every portfolio or investing entity must be examined to make sure it will be able to survive that bad day – that it has been set up so the interaction of its terms, its borrowings and the riskiness of its assets won’t cause it to implode. Of course, this leads to the question of how negative a set of circumstances we should allow for. Each investor’s degree of risk averseness will determine what level of negative developments a portfolio should be built to withstand. But certainly these are topics that must be considered. When I think about investors using leverage to try to wring acceptable results from low- return investments, it seems like folly.

But before we could make the loan, someone else made the company a better offer: more leverage on cheaper terms, with no provision for accounting due diligence. When later we were able to ask about why we had lost out, we were told that one reason the other lender was able to be more aggressive than Oaktree was the fact that it had “pre-syndicated” most of the loan to hedge funds. This was accomplished in the absence of financial statements or accounting due diligence, but with validation from the high trading price of the company’s public securities (which was being set, again, in a financial-statement void). Okay, so the lender’s risk was limited. But how about the funds that bought the loan?  UComplexity Outruns AnalysisU – Wall Street is incredibly inventive. It’s staffed by bright people, pursuing massive incentives, trying to out-think their competitors in order to win assignments to serve companies’ financial needs. Sometimes this results in structures that few people understand, fraught with hidden risks. My latest nominee is the CPDO, or Constant Proportion Debt Obligation. CPDOs provide capital to finance structured entities writing credit insurance on investment grade debt. Because this debt entails little credit risk, the returns that can be earned from writing credit insurance on it are similarly low. Thus, these entities have to lever up substantially – typically 15-to-1 – to provide the LIBOR+200 returns promised on the bottom-tier CPDO.

, Carlyle and KKR) that formed highly leveraged subsidiaries that would employ extensive leverage in the pursuit of profit,  anyone dependent on issuing commercial paper or other forms of short-term debt to finance leveraged investments, and  CLOs and CDOs, their investors, and those who depended on them to continue buying debt providing inadequate risk compensation. The list of affected areas is long and could grow longer. On bad days, losses on U.S. stocks, European stocks and emerging market stocks all are attributed to the credit crunch. Exchange rate swings – and strength in the yen in particular – are blamed on declining use of the carry trade, a regular feature of which was borrowing at low rates in Japan and investing for more elsewhere. And the other day, I read that lower profits at London investment banks will likely result in smaller bonuses for investment bankers . . . and thus in lower prices for London real estate. How could investors in the areas listed above have expected that a crisis in subprime mortgages would affect them this way? Who would have guessed, for example, that low- grade mortgage delinquencies would depress returns on risk arb funds?

Let’s see: You have $100 to invest, and you come across a fundamentally sound investment that yields 6%. But you consider the 6% return too low. So rather than buy $100 worth, you borrow another $400 at 5% interest and buy $500 worth. If you can borrow at 5% and invest at 6%, each “turn” of leverage adds 1% to your expected return. Thus, in addition to the $6 earned on your own $100 of capital, you’ll earn an additional $1 per $100 of borrowed capital, or $4 on $400. Thus the total return on your $100 of capital, leveraged four times, is $10. Voila! That inadequate 6% return has been turned into a handsome 10%.

© Oaktree Capital Management, L.P. All Rights Reserved But wait a minute. Remember, you originally thought the 6% return on the investment was too low. What happens when everyone comes to agree that it should be higher? Well, the normal way for an investment’s prospective return to go up is for its price to fall. So now, with help from leverage, you’ve bought five times as much of an asset that’s under-returning and due for a price decline. It all reminds me of my friend Sandy, whose favorite restaurant review is “the food’s terrible, but the portions are huge.” In this case, it’s “the return’s inadequate, but thanks to leverage you can buy a lot.” Is that a good thing? UGarbage In, Garbage Out This expression was in broad circulation 10-20 years ago, but I haven’t heard it much lately. It’s meaning is simple: models and decision-making processes can’t produce good decisions if they don’t begin from valid inputs. Roughly stated, I think all computers can do is maintain and search data bases, compare one thing against another, and perform calculations. They cannot think (yet). I think the importance of this for financial decision makers is that while computers can find, verify and extrapolate relationships that have held in the past, they can’t tell when those relationships will cease to work and what new relationships will take their place. Put another way, computers know a lot about the past but much less about the future.

© Oaktree Capital Management, L.P. All Rights Reserved How did the increase in subprime mortgage delinquencies lead to last week’s 580 point drop in the Dow? These are some of the ways. Fault lines run through portfolios, markets and economies, and usually they are exposed only in times of crisis. The fault line this time came in the form of pervasive leverage. UThe Role of Psychology At the end of each day, Oaktree’s debt trading desk sends out an email recapping our buys and sells, along with market developments and the day’s biggest headlines. On July 26, (the day the Dow declined 312 points), one of the headlines read “Paulson Says Subprime-Mortgage Collapse Doesn’t Threaten Economic Growth.” On the simplest level, there’s every reason to understand that the failure to make monthly payments on the part of a bunch of mortgage borrowers at the bottom of the credit ladder won’t have direct effects far beyond their local communities and the holders of their loans. But (1) the government usually does a poor job of anticipating second-order consequences and (2) politicians have every incentive to act as cheerleaders for the economy and downplay the negatives. Unlike distressed debt investors and other bargain hunters, no officeholder wants to see economic weakness, since it tends not to do much for re-electability.

The New York Times of August 18 described A Demon of Our Own Design, by Richard Bookstaber (see “Investment Miscellany,” November 2000) as pointing out that “the proliferation of complex financial products like derivatives, combined with use of leverage to bolster returns, will inevitably mean that there will be a regular stream of market contagions like the one we’re having now – one of which, someday, could be calamitous.”

© Oaktree Capital Management, L.P. All Rights Reserved beneath a portfolio of bonds averaging single-A, leveraged up 15-to1, gets a triple-A rating. Huh? Second, as the Financial Times wrote on November 13, “if there are losses and the CPDO’s net asset value begins to fall from its target, the leverage is increased to try to earn more at a faster rate.” In other words, if you did a little of something and it didn’t work, try to recoup your losses by doing a lot.  U What Due Diligence?U – The other day, Orin Kramer (see “Pigweed”) observed skeptically that “the most profitable way to be a lender today is to have no underwriting department.” In other words, default rates are too low, and the market is too competitive, for credit analysis to be worth paying for. In December, Reuters described a takeover bid whose competitiveness was enhanced by a reduced due diligence period and a short list of information requirements. And most interestingly, one of the major investment banks told us recently that on most syndicated loans, about 70% of the buyers never visit the data rooms set up to facilitate due diligence.  UPut the Pedal DownU – FT.com pointed out on January 21 that, “One-tenth of the capital committed [to private equity funds] in 2002 was . . . put to work within one year. For funds invested in 2005, the corresponding proportion was almost 30 percent.

© Oaktree Capital Management, L.P. All Rights Reserved This pattern of contagion exemplifies the hidden fault lines that I say can run through portfolios and – like construction flaws in California homes – become apparent only during infrequent catastrophes. But their invisibility most of the time doesn’t mean they’re not there. The existence of these common threads is one of the things that make it difficult to predict the correlation between assets, one of the key ingredients in intelligent portfolio construction. And it’s a good reason to attach a significant premium to managers with alpha, or superior investment insight and skill. ULeverage and Liquidity It’s clear that when the story of 2002-07 is written, leverage and liquidity will be among the main players. For much of the last few years, we saw a vast appetite for securities. It created enormous demand for – and pushed up prices of – real estate- and asset-backed paper, CLO and CDO debt, buyout funds, hedge funds, high yield bonds and leveraged loans. In fact, there seemed to be unlimited demand for non-mainstream investments. With all that money to put to work, few potential buyers refrained from participating in an upswing that some observers thought lacked a sufficient raison d’être, reasonable limits and adequate risk compensation. One of the factors contributing most strongly to that demand was an ability to borrow excessive amounts, for questionable purposes, on loose terms and at a low cost.

© Oaktree Capital Management, L.P. All Rights Reserved * * * In the last few weeks, investors have learned some painful lessons. They went from feeling they understood exactly what was going on to realizing they merely had been carried along in a rosy environment. They learned (1) that they hadn’t accurately gauged the risks they were taking when they invested in innovative and highly leveraged structured entities, (2) that the rating agencies they’d relied on didn’t know either, and (3) that in understating risk they hadn’t demanded enough of a risk premium or sufficient protective covenants. They learned the hard way that leverage magnifies losses as well as gains. And they learned that negative developments in a far-off corner of the economy can affect them profoundly. There’s absolutely nothing new in any of this.

It was a result of the unattractiveness of yields on high grade debt . . . which stemmed largely from the Fed’s campaign to lower interest rates in order to mitigate the depressant effect of the stock market slump and recession. It was abetted by the fact that after a few years of good results, many people forget how money is lost. Extensive use of leverage was behind many of the gains of the last few years, and it is at the root of many of the problems being suffered today. If I mistake not, the distress . . . was produced by an enemy more formidable than hostile armies; by a pestilence more deadly than fever or plague; by a visitation more destructive than the frosts of Spring or the blights of Summer. I believe that it was caused by a mountain load of DEBT. Flowery commentary on the crisis of 2007? No; according to the Financial Times, the quote from T.E. Burton’s Crises and Depressions refers to events that occurred in 1857. The point is that leverage is nothing new, and neither are its deleterious effects. There are numerous reasons to use debt to leverage results, and none of them is likely to evaporate any time soon: 1. Hope springs eternal, as my mother used to say, and greed usually drives markets. Thus any tool that has the power to magnify gains is very tempting.

© Oaktree Capital Management, L.P. All Rights Reserved 2. Of course, leverage can magnify losses as well as gains. But investors make investments because they expect them to work, not fail, and thus the attraction of magnified gains far outweighs the fear of magnified losses. 3. Long-term bonds almost always offer higher yields than short-term debt, and riskier investments invariably seem to promise higher returns than safe ones. For these reasons, using short-term borrowings to finance lower grade and/or longer-term investments invariably appears likely to produce positive returns. 4. Most seductively, the incremental risk entailed in investments that are slightly longer in term or slightly lower in quality usually appears quite small. For this reason, these trades seem safe – but that doesn’t mean they can’t be rendered extremely risky when leveraged up enough. 5. Of course, when an upward cycle is generating strong returns and making risk aversion recede, the equation becomes even more attractive. In the FT column that provided the above quotation, John Authers describes the regular pattern of good times, easy credit, increasing leverage and eventual crashes. I don’t see that ever changing. It’s for these reasons – and especially #4 – that highly leveraged positions are at the root of most fund collapses.

© Oaktree Capital Management, L.P. All Rights Reserved The investment environment of the last few years could have been negatively impacted by the removal of any one of the elements of liquidity listed above. But if you look at the list, it becomes clear that they’re highly interrelated. Weakening one assumption could render the others less reliable. And, in truth, a single exogenous development – such as a major decline in psychology – could simultaneously harm them all. That’s the main story of the last few weeks. Investments costing many times the investor’s equity. Dependence on unreliable short-term financing. Susceptibility to margin calls or capital withdrawals. Assets that can become unsalable at a moment’s notice. Prices that can collapse because the markets are thin and everyone wants out at the same time. The formula is simple and the results are predictable. Not every fund that’s so disposed collapses, but the potential’s always there – with borrowing to buy at its core. Fundamental problems are present in most investment conflagrations, but exposure to excessive leverage and disappearing liquidity is often the accelerant. As breakingviews.com (my new favorite) put it in The Wall Street Journal of August 2, “The markets may hurt you, but your lenders will finish you off.” URisk Reduction Of the many fairy tales told over the last few years, one of the most seductive – and thus dangerous – was the one about global risk reduction.

Thus, everything else being equal, the bigger the boom – the greater the excesses of the capital markets in the upward direction – the greater the bust. Timing and extent are never predictable, but the occurrence of cycles is the closest thing I know to inevitable. And usually, the air goes out of the balloon a lot faster than it goes in. * * * Today’s financial market conditions are easily summed up: There’s a global glut of liquidity, minimal interest in traditional investments, little apparent concern about risk, and skimpy prospective returns everywhere. Thus, as the price for accessing returns that are potentially adequate (but lower than those promised in the past), investors are readily accepting significant risk in the form of heightened leverage, untested derivatives and weak deal structures. The current cycle isn’t unusual in its form, only its extent. There’s little mystery about the ultimate outcome, in my opinion, but at this point in the cycle it’s the optimists who look best. As is often the case, I could have made this a shorter memo by simply invoking my two favorite quotations, both of which have a place here. The first is from John Kenneth Galbraith, who passed away last year. I was fortunate to be able to spend a few hours with Mr.the

It went this way:  The risk of economic cycles has been eased by adroit central bank management.  Because of globalization, risk has been spread worldwide rather than concentrated geographically.  Securitization and syndication have distributed risk to many market participants rather than leaving it concentrated with just a few.  Risk has been “tranched out” to the investors best able to bear it.  Leverage has become less risky because interest rates and debt terms are so much more borrower-friendly.  Leveraged buyouts are safer because the companies being bought are fundamentally stronger.  Risk can be hedged by long/short and absolute return investing and through the use of derivatives designed for that purpose.  Improvements in computers, mathematics and modeling have made the markets better understood and thus less risky. As described in “It’s All Good . . . Really?” I thought many things that hinted at risk reduction actually had the effect of decreasing understanding and increasing risk. Up to July, all we read about was the beneficial nature of these developments.periodicals:

© Oaktree Capital Management, L.P. All Rights Reserved doesn’t mean things can’t be worse in the future. In 2007, many people’s worst-case assumptions were exceeded. 5. Risk shows up lumpily. If we say “2% of mortgages default” each year, and even if that’s true when we look at a multi-year average, an unusual spate of defaults can occur at a point in time, sinking a structured finance vehicle. Ben Graham and David Dodd put it this way 67 years ago: “. . .the relation between different kinds of investments and the risk of loss is entirely too indefinite, and too variable with changing conditions, to permit of sound mathematical formulation. This is particularly true because investment losses are not distributed fairly evenly in point of time, but tend to be concentrated at intervals . . .” (Security Analysis, 1940 Edition). It’s invariably the case that some investors – especially those who employ high leverage – will fail to survive at those intervals. 6. People overestimate their ability to gauge risk and understand mechanisms they’ve never before seen in operation. In theory, one thing that distinguishes humans from other species is that we can figure out that something’s dangerous without experiencing it. We don’t have to burn ourselves to know we shouldn’t sit on a hot stove. But in bullish times, people tend not to perform this function. Rather than recognize risk ahead, they tend to overestimate their ability to understand how new financial inventions will work. 7.

Perhaps Myron Scholes put it most succinctly (The Wall Street Journal, March 6): “My belief is that because the system is now more stable, we’ll make it less stable through more leverage, more risk taking.” UThe L Word Some of the most glaring innovation this time around has taken place in the area of leverage. It’s not that leverage hasn’t been available and been used before: In the late 1980s, companies like RJR were the subject of leveraged buyouts in which 95% of the purchase price was borrowed. Nowadays, debt rarely constitutes much more than 80% of buyout capital structures, but the terms of the debt and the ease of obtaining it are startlingly accommodating. Unlike the historic norm, it’s routine today to issue CCC-rated bonds. It’s easy to borrow money for the express purpose of distributing cash to equity holders, magnifying the company’s leverage. It’s so easy to issue bonds with little or no creditor protection in the indenture that a label has been coined for them: “covenant-lite.” And it’s possible to issue bonds whose interest payments can be paid in more bonds at the option of the borrower. The first requirement for an elevated opportunity in distressed debt is the unwise extension of credit, which I define as the making of loans which borrowers will be unable to service if things get a little worse. This happens when lenders fail to require a sufficient margin of safety. Here the interrelatedness of cycles is quite evident.

© Oaktree Capital Management, L.P. All Rights Reserved stay afloat and hopefully outgrow their problems. Today that’s called “rescue finance”; in less rosy times it might be called “throwing good money after bad.” The default rate in the high yield bond universe is at a 25-year low on a rolling-twelve-month basis. Under such circumstances, how could the average supplier of capital be expected to maintain a high level of risk aversion and prudence, especially when doing so means ceding all the loan making to others? It’s not for nothing that they say “The worst of loans are made in the best of times.” UThe Downside of Leverage If lenders are acting in an imprudent fashion, what’s the effect on the borrowing companies? If loans are available too readily, is it right or wrong to borrow? These are among the most interesting questions of the day. Lots of good things have been said about leverage. In the late 1980s, when venerable American companies were being bought in leveraged buyouts structured with debt/equity ratios of 25-to-one, we were told that an underleveraged balance sheet is indicative of a sub-optimal capital structure and excessive use of high-cost equity, and that significant leverage sharpens management’s focus on cash flow and leads to better expense control. The only thing omitted was the reminder that equity – which doesn’t require the periodic payment of interest or the repayment of principal at maturity – represents a company’s margin of safety.

It’s the capital layer that absorbs the first blow in tough times without occasioning an event of default. While leverage may magnify gains in good times, it’s a healthy layer of equity that gets companies through the bad times. It’s inescapable that, all other things equal, greater leverage increases a company’s likelihood of experiencing financial distress. Thus, with lenders enjoying a carefree recent experience and consequently financing some unwise deals – and with borrowers eager for the enhanced upside potential that comes with leverage – it seems clear that we’ll see rising rates of default and bankruptcy a few years down the pike. This is especially true if, as has often been the case recently, debt is incurred not just to leverage the company’s equity, but to finance payouts to equity holders that reduce or eliminate the equity. So then, are private equity funds – raising much more equity capital than ever, and doing the biggest deals in history at a rapid-fire pace, at rising transaction prices and rising leverage ratios – doing a smart thing or making a mistake? It all depends on how you look at things. The funds seem to be looking in terms of optionality. UKetchup, Easy Money and Optionality I was a picky eater when I was a kid, but I loved ketchup, and my pickiness could be overcome with ketchup. I would eat hamburgers, frankfurters, veal cutlets, filet of sole and frozen fish sticks, but as far as I was concerned, they were all just vehicles for ketchup.

But when money’s everywhere, unqualified borrowers are offered money on a silver platter. The inevitable results include delinquencies, bankruptcies and losses. 3. When capital is in oversupply, investors compete for deals by accepting low returns and a slender margin for error. When people want to buy something, their competition takes the form of an auction in which they bid higher and higher. When you think about it, bidding more for something is the same as saying you’ll take less for your money. Thus the bids for investments can be viewed as a statement of how little return investors demand and how much risk they’re willing to accept. 4. Widespread disregard for risk creates great risk. “Nothing can go wrong.” “No price is too high.” “Someone will always pay me more for it.” “If I don’t move quickly, someone else will buy it.” Statements like these indicate that risk is being given short shrift. This cycle’s version saw people think that because they were buying better companies or financing with more borrower-friendly debt, buyout transactions could support larger and larger amounts of leverage. This caused them to ignore the risk of untoward developments and the danger inherent in highly leveraged capital structures. 5. Inadequate due diligence leads to investment losses. The best defense against loss is thorough, insightful analysis and insistence on what Warren Buffett calls “margin for error.

Matthew Rothman of Lehman Brothers has become famous for saying in early August that “events that models only predicted would happen once in 10,000 years happened every day for three days.” Are those models you want to bet on?  UDi-worst-ificationU – Warren Buffett harps on the folly of branching out into things you know less about solely for the purpose of increasing the number of baskets in which you have your eggs. Investing in things about which you aren’t expert doesn’t reduce risk, it increases it. And I think it’s particularly unwise to finance diversification with borrowed money.  UConflicts between managers and clientsU – Investors should look very closely at the alignment of their managers’ interests with their own. The mere fact that a manager is working for incentive compensation, or has money in his fund, isn’t enough. Recent events have shed some unusual – and provocative – light on the question of alignment. Consider Sowood Capital, which lost half of its investors’ capital, sold off its portfolio in a block and closed down. Why did the loss of half the LPs’ equity occasion a liquidation? Might further losses have activated a clawback of previous years’ incentive fees? And might the interests of a manager with 100% of his net worth in his fund have diverged from the interests of LPs who invested 1% of theirs?

Anything can happen in this regard, with results that are both unpredictable and irrational. 9. Markets change, invalidating models. Accounts of the difficulties of “quant” funds center on the failure of computer models and their underlying assumptions. The computers that run portfolios primarily attempt to profit from patterns that held true in past markets. They can’t predict changes in those patterns; they can’t anticipate aberrant periods; and thus they generally overestimate the reliability of past norms. 10. Leverage magnifies outcomes but doesn’t add value. It can make great sense to use leverage to increase your investment in assets at bargain prices offering high promised returns or generous risk premiums. But it can be dangerous to use leverage to buy more of assets that offer low returns or narrow risk spreads – in other words, assets that are fully priced or overpriced. It makes little sense to use leverage to try to turn inadequate returns into adequate returns. 11. Excesses correct. When investor psychology is extremely rosy and markets are “priced for perfection” – based on an assumption that things will always be good – the scene is set for capital destruction. It may happen because investors’ assumptions turn out to be too optimistic, because negative events occur, or simply because too- high prices collapse of their own weight. 12. Investment survival has to be achieved in the short run, not on average over the long run.

© Oaktree Capital Management, L.P. All Rights Reserved I know that this liquidity environment cannot go on forever. I know that the longer it lasts the more money our investors (and we) will make. I know that the longer it lasts, the greater the pressures will be on all of us to take advantage of this liquidity. And I know that the longer it lasts, the worse it will be when it ends. And of course when it ends the buying opportunity will be a once in a lifetime chance. But, I do not know when it will end. . . . Last year, I asked you to be humble, ethical and optimistic. This year I am asking you to be careful as well. In 1990-91, our distressed debt funds made a fortune buying the obligations of companies that had been loaded up with too much debt in LBOs in the late ’80s. Chastened by that experience, lenders in the ’90s didn’t provide enough leverage to make buyout companies much of a factor in the debt collapse of 2002. But with the memory of having 1990-91 faded, leverage became freely available in the last few years, and thus we have little doubt we’ll be buying a great deal of distressed LBO debt the next time around. When all the above is taken together, it seems likely that a few years out, we’ll see a landscape littered with companies that were crippled with excessive debt loads and lenders who weren’t repaid.

Stimulative action that looked like an investor bailout would contribute further to moral hazard and the expectation that the Fed will always protect investors on the downside. This is an unhealthy expectation, as each bailout encourages risk taking and thus increases the likelihood that another will be needed. But the Fed is being importuned for a rate cut, and there are few people to argue on the other side, for a good dose of unpleasant medicine. I’m usually cautious, so I might as well keep my record intact. The economy should weaken. Deals built on optimistic assumptions and paid for with a lot of borrowed money shouldn’t all thrive. Generous capital markets should not be expected to bail out ailing companies. Bargain hunters and distressed debt investors will have more to do. Eventually. But no one at Oaktree would advise you to act as if these views are sure to be correct. We certainly won’t. * * * TAn observation I made last October regarding the meltdown of Amaranth, in “Pigweed,” is equally applicable to the recent problems: TOrin [Kramer] notes that Amaranth “occurred when the skies were blue; the fund unraveled because a small and volatile commodity behaved in an unpredicted fashion.” This collapse didn’t require an adverse economic environment or a market crash. The combination of arrogance, failure to understand and allow for risk, and a small adverse development can be enough to wreak havoc.

It certainly seems inevitable that, eventually, investment merit becomes overpriced, and the combination of good results and easy money causes dangerous leverage to be employed in the pursuit of profit. When will market cycles be banished or made more muted? That’ll happen when greed, human failings and herd behavior are eliminated. Or, in other words, never. In “You Can’t Predict. You Can Prepare.” I wrote of cycles that success carries within itself the seeds of failure, and failure carries the seeds of success. It’ll always be so.2007

© Oaktree Capital Management, L.P. All Rights Reserved  Willingness to bear risk is up.  Insistence on high risk premiums is down.  Skepticism is down, and there’s widespread willingness to suspend disbelief.  Demand for t-crossing and i-dotting is in retreat.  Quantity can replace quality as the sine qua non for portfolio construction. I’ll provide a few examples below to illustrate what I think is going on in the alternative markets. UBuyouts: Where’s the Magic? A startling revolution has taken place among buyout funds in the last year or so. Let’s take a look at how we got here. So many of the big-name, highly leveraged buyouts of the late 1980s went bankrupt in 1990 – Macy’s, Federated, National Gypsum, etc., etc. – that the industry had to recreate itself, dropping the discredited word “leveraged” and the previously ubiquitous acronym LBO. Instead, the industry began to call what it does “buyouts” or “private equity.” It switched its model from loading massive leverage on venerable, multi-billion dollar companies to the mantras of “platform and buildup” and “consolidate the industry.” In the 1990s, the low levels of leverage permitted by chastened lenders kept the buyout boys from closing any landmark acquisitions, but also from loading on enough debt to render their companies vulnerable to distress. In order to lose huge amounts of capital, buyout funds had to venture into the tech and telecom arenas, and relatively few rose to the occasion.

The answer’s simple: Positions that are low in risk can be rendered quite risky with the help of leverage. Back in ancient history (1998), a fixed income hedge fund called Long-Term Capital Management pursued arbitrage transactions like Amaranth’s (on a much more diversified basis but with more leverage) and experienced a similar meltdown.things

© Oaktree Capital Management, L.P. All Rights Reserved “The less prudence with which others conduct their affairs, the greater the prudence with which we should conduct our own affairs.” Imagine we ran into a visitor from Mars who observed, “I see your economy and markets have been doing well for years. Everyone’s making a ton of money. No one’s expressing worry or a desire to avoid risk. P/E ratios, buyout prices and private equity leverage ratios are all high. Stock buybacks and dividend recaps are adding to leverage and reducing creditworthiness. Conferences on hedge funds and private equity are sold out. Top-performing funds are closed to newcomers and new ones start up every day, fully subscribed. The Greenwich Ferrari dealer has a waiting list a year long.” Nothing in our favorite Martian’s statements sounds like a prediction. In fact, he hasn’t said one word about the future. But there’s a lot of helpful information there. My guess is valuable inferences could be made about what’s likely to happen next. If he can see it, so should we. And having seen it, we should take appropriately cautious action. And the reverse can also be true (although it’s not something I dwell on most of the time or at what I think is today’s point in the cycle).

© Oaktree Capital Management, L.P. All Rights Reserved were going well, one of Long-Term’s principals had said, “We’re going around the world scooping up nickels and dimes.” There’s great appeal to his notion of profiting from a large number of small mispricings that others aren’t smart enough to seize upon. But he had left off a few key words from the end of his sentence: “. . . in front of a steamroller.” The steamroller enters the picture when so much leverage is employed that a fund can’t survive a moment of aberrant market behavior. TIn a memo on hedge funds in October 2004, I mentioned that when there’s a big increase in the number of little fish attempting to live off each big fish’s leavings (or in the number of hedge funds relative to mainstream investors), the pickings become slimmer. Given the increased efforts to exploit inefficiencies today and the fact that strong cash inflows and resultant high prices have depressed prospective returns in many markets, managers are often resorting to increased leverage in order to reach their return targets. But it’s essential to remember that leverage is the ultimate two-edged sword: it doesn’t alter the probability of being right or wrong; it just magnifies the consequences of both. TUThe Perils of Diversification TThe Amaranth saga demonstrates that the riskiness of a portfolio is not just a function of the fundamental nature of its holdings, but also of things like concentration and leverage.

I often say there is no investment so good that it can’t be ruined by too-high an entry price. There’s also no investment so safe that can’t be rendered risky by buying too much of it with borrowed money. TDiversification has long been considered a pillar of conservative investing. It’s a simple concept: “Don’t put all your eggs in one basket.” Spreading your capital among a number of assets or strategies reduces the likelihood of a disaster. TIn the 1960s, Bill Sharpe pointed out that adding in a risky but uncorrelated asset can reduce a portfolio’s overall riskiness. It has become accepted wisdom that overall risk can be reduced (and return increased) by adding alternative investments to a portfolio of stocks and bonds. TBut people don’t always take note of a dangerous outgrowth of these dicta: that diversifying into uncorrelated assets with borrowed money can increase, not reduce, the risk of the portfolio. TLet’s say you have $100 invested in U.S. stocks. You realize how undiversified your portfolio is, and that a market crash can bring a substantial loss. So you sell off $75 worth of stocks and put $25 each into emerging market stocks, high yield bonds and natural gas futures. Now your portfolio is invested equally in four asset classes rather than one and thus probably safer. TBut what if, instead, you hold onto your $100 worth of U.S. stocks and borrow another $300, investing $100 in each of those three new asset classes.

© Oaktree Capital Management, L.P. All Rights Reserved TA crash that wipes out one of the four asset classes in the diversified $100 portfolio will reduce your net worth by 25%. But that same crash, when experienced in the leveraged and equally diversified $400 portfolio, will eliminate your entire net worth. So investors should always consider the combined effect of diversification and leverage. Amaranth was much safer when it was all in convertible arbitrage than after it increased its leverage in order to diversify into energy trading. Diversification is a good thing, but a lot depends on how you finance it. T“Multi-strategy” is one of today’s hot buzz words. But as Orin Kramer puts it (see page 12 for who he is), “Amaranth is a reminder that a multi-strategy structure is not a proxy for risk diversification.” That is, I think, multi-strategy + risk control = protective diversification, while multi-strategy + leverage = more ways to lose. UGenerating Alpha I want to say up front that I have absolutely no idea how one dependably achieves above average profits from trading or investing in commodities, precious metals or currencies. That’s not to say it can’t be done. There are people who’ve gotten very rich that way, managing both their own money and that of others.

I believe the largest pools of investment capital have given up on getting the returns they need from now-debased equities and have turned to buyouts and the like for help. I imagine a thought process that goes like this: “Historically, good buyout funds have had returns in the high teens net of fees. Even though the environment isn’t what it used to be, it should be a lay-up for them to reach the low teens. I’d even be happy with 10%; it would certainly help me with my 8% required return. And I can put a billion to work in one phone call.” Well, I’m not sure many buyout firms have produced historic average returns in the high teens. (According to Bloomberg, “U.S. buyout funds produced returns of 13.3% during the past two decades.”) And even if the best did, that doesn’t mean earning even low teens will be easy in the environment ahead. Finally, I’m not convinced that returns in the low teens are enough to make it worth bearing the risk that comes with leverage, illiquidity and competition for deals. But the money flowing into buyout funds makes it clear that I’m in the minority. UThe Outlook for Buyout Returns Investors – in any field – can make money in four broad ways: buy cheap, add value, apply financial engineering and sell dear. Let’s examine each one as it applies to buyouts. UBuying cheapU – The golden age of buyouts lasted from approximately the mid-1970s to the mid- 1980s. What was the environment like as that period began?

 The stock market was in a terrible slump, with Business Week heralding “The Death of Equities.”  Companies could be bought cheaper through the stock market than they could be built for.  Historically, before the age of leverage, one company could buy another only if the would-be acquirer was larger than the target. Thus the competition to acquire was limited.

Withdrawing equity in order to leverage up the IRR doesn’t add any value. It couldn’t be done in the stingier debt market of five years ago, and it may not be doable five years from now if a business slowdown shows lenders its folly. Rising interest rates would be a negative, and factoring in a more restrictive capital market would ring the bell on radical financial engineering for a while.

And shouldn’t the seller know the company best (and be expected to have made the available improvements)? So are the selling buyout funds being generous? Are buyers overpaying? Or are the transactions motivated by a desire to lock in incentive fees and generate further deal fees? If there is a free lunch, where’s it coming from? I’ll leave those questions to you. Buyout prices have been rising as a multiple of company earnings, and companies are being bought with greater proportions of debt in an attempt to squeeze out higher returns on the buyout firms’ equity. As companies become more highly geared, the outcomes become more dependent on a favorable environment. As they say in Las Vegas, “The more you bet, the more you win when you win.” But, simply put, when you increase leverage, the probability of getting into a jam increases and the consequences of that jam worsen. Certainly this is not a cautious, capital-starved environment for buyouts in which people have girded for tough times. I have to admit it: if I could push the fast-forward button and see how a movie ends, it would be this one. Like most “silver bullets,” I think buyouts will fail to live up to the highest expectations of those who’re making it the darling of the investment world today. I find the outlook for funds in the “big buyout” category particularly intriguing.

There simply is no cookie-cutter method – no single calculation – that considers them all.  The internal rate of return,  The times-capital-returned,  The percentage of the capital that was put to work,  The speed at which that capital was put to work,  When investments were harvested and distributions made,  What the LPs were able to do with capital that remained uncalled and/or was returned,  What the LPs could have done with the capital that was called and/or not returned. Finally, it’s important – as in all other areas of investing – to consider how much risk a fund took to earn its return. We’ve become accustomed to evaluating managers of public securities on the basis of risk-adjusted returns, but this approach hasn’t equally reached the alternative markets. Part of this is because alternative assets generally haven’t been marked to market, and thus there are no meaningful figures for volatility (without those simplistic measurements, risk analysis becomes a real challenge – see “Risk,” January 6, 2006). But clearly, for an oversimplified example, if buyout funds X and Y buy similar kinds of companies and end up with similar IRRs and TCRs, but Fund X uses far less leverage than Fund Y, I would tend to say that Fund X did a superior job. Their IRRs and TCRs alone tell us nothing about their respective riskiness.

© Oaktree Capital Management, L.P. All Rights Reserved How are we to make distinctions when the assets purchased aren’t comparable or the differences in leverage and results are less than dramatic? What if one fund buys companies that are more solid than another’s? How do we compare a leveraged buyout fund against an unleveraged venture capital fund (with its very low expected batting average)? Which is riskier, a highly leveraged portfolio of safe assets or an unleveraged portfolio of risky assets? It’s hard to make these judgments, but that doesn’t mean they’re unimportant. And while I’m on the subject of evaluating performance records, I want to raise the subject of unevenness in the quality of performance data. Some managers mark their private holdings to market and others carry them at cost. Some managers are more optimistic than others in marking to market. Some managers discount large holdings of public securities for illiquidity while others do not. And some managers highlight the results on just their realized investments, which invariably are the best. For these and other reasons, IRR or TCR figures simply can’t be accepted at face value for funds that are still in operation and thus haven’t turned all or almost all of their investments into cash. U Which Return Matters? – Real-Life Example #2 Another look at our real-life experience will give a clear view of the absolute conundrum posed by performance assessment.

But today the necessary ingredient for the establishment of these structured vehicles isn’t credit expertise, but the ability to structure the entity so as to win high-enough ratings on the senior tranches to attract capital and permit a lot of leverage. This distinction is highly significant. In a clear analogue to real estate appraisers, the people controlling the all-important credit spigot are the financial structurers assembling the entities and the CDO analysts at the credit rating agencies. In a June 2 article entitled “Structured Complacency,” the often-brilliant “Grant’s Interest Rate Observer” went into great (and, as usual, critical) detail on this phenomenon. As to the popularity of structured vehicles, it wrote, “Credit markets are sanguine. Structured credit is proliferating. Could the first fact be related to the second?” And as a key part of this trend, it says, “Financial engineering is displacing credit analysis.” What’s the difference? “Financial engineering is the science of structuring cash flows; credit analysis is the art of getting paid.” Why the declining interest in credit analysis? Grant’s advances the thesis that it is linked to disintermediation, in which many lenders no longer hold on to the loans they make, but more often syndicate or sell them onward to other providers of capital.

© Oaktree Capital Management, L.P. All Rights Reserved Value-added funds that generate alpha clearly are an essential ingredient if portable alpha is going to work. Many managers claim the ability to generate alpha based on their skill, experience and access to alpha-generating strategies. But only the best will prove able to accomplish the difficult task of obtaining true alpha, after returns have been adjusted to recognize embedded beta bets. Thus real alpha may not always be responsible for portable alpha’s contribution. In my opinion, a more common reason for a portable alpha portfolio to deliver higher returns over time may be that it entails leverage. Because the value-added funds may not be as “market neutral” or “absolute return” as is thought – and because portable alpha managers may fail to properly adjust for embedded betas – the market exposure delivered by the total portfolio can end up being more than would be entailed in its benchmark (e.g., a traditional long-only stock portfolio). In that case, the portable alpha portfolio will represent a leveraged position. (That is, the sum of the beta on the derivatives plus the beta on the funds may exceed the beta of a traditional stock portfolio.) If that’s true, the portable alpha portfolio should provide higher returns in up markets than the traditional portfolio.

This demonstrates that when a company increases its debt, the impact of subsequent developments is magnified. That’s why borrowing is also called leverage . . . and why borrowing makes companies riskier. But what if it borrows money and gives it to the shareholders? Take the same company with $200 of debt and $200 of equity. Assume again that it borrows $100, but this time, rather than buy assets, it distributes the cash to its equity investors. Now it has $300 of debt and $100 of equity supporting the same $400 of assets, and it takes just a 25% decline in the value of its assets to erase its equity. So whereas all borrowing makes companies riskier, borrowing for dividends greatly amplifies the effect, as the assumption of debt doesn’t lead to either the acquisition of productive assets UorU an increase in cash reserves, but merely a decrease in shareholders’ equity. For this reason, lenders should view borrowing for dividend distributions with extreme skepticism. But it is a feature of the current capital market environment – with its excess of enthusiasm and shortage of caution – that transactions designed to replace equity with debt have become commonplace. According to CSFB, in the 36 months that began April 1, 2003, $68 billion was borrowed through high yield bond issuance or bank loans with the stated purpose of paying dividends or repurchasing stock, whereas deals of this sort were largely unheard of prior to that date.

This will be so as long as traditional managers’ alphas aren’t sufficient to offset both the leverage and the value-added fund managers’ alphas (which everyone assumes is out of the question given today’s belief in alternative funds and disrespect for traditional investing). But the portable alpha portfolio may lose more in down markets unless the value-added fund managers’ alpha exceeds the traditional managers’ alpha by enough to offset the increased losses that can stem from a portable alpha portfolio’s leveraged market exposure. Now then, if pension funds or endowments aren’t permitted to borrow to achieve leverage and want to increase market exposure this way, I say “have at it.” But they should call it what it is, rather than insist that they’re combining 2 plus 2 and getting 5. And remember that even after a portable alpha program has been in place for a period of years and produced results ahead of its benchmarks, it may not be possible to accurately assess whether the advantage came from the skill of the value-added managers, the effectiveness of the portable alpha approach, or leveraged market exposure. Because risk often is truly invisible, you can’t always tell how much market risk you bore, and thus whether the key was really alpha or beta. Portable alpha has the potential to improve results – in good markets and generally over time (since markets usually go up).

© Oaktree Capital Management, L.P. All Rights Reserved THillary Till describes Amaranth’s loss as a 9-standard-deviation event (Long-Term Capital’s is estimated at “8-sigma”). By way of reference, 5 standard deviations include the central 99.99994% of a Tnormal probability distribution. A 5-sigma event below that range should happen about three times in every ten million trials (thus a given daily occurrence should happen once every 10,000 years). But it’s amazing how often this kind of event seems to occur when derivatives are combined with leverage. TEveryone speaks about preparing for “worst-case” outcomes, but invariably things can get even worse. Statistical reassurance should be relied on only to a reasonable extent. Common sense has to come into play as well. TU Risk Management and Risk Managers TYou know from my memo of February entitled “Risk” that I’m not a big fan of quantitative risk management. It’s often said of a man that “he knows the price of everything but the value of nothing” – and it’s not meant as a compliment. Likewise, I feel effective assessment of portfolio risk is less likely to come from Ph.D. statisticians who lack intimate knowledge of the assets in the portfolio than through wise judgments made subjectively by investors possessing “alpha.” TIn the memo on risk, I enumerated several criteria that should be present if modeling is to prove effective. I also observed that most of them are lacking in the investment world.

© Oaktree Capital Management, L.P. All Rights Reserved companies have appreciated in value in the last few years, but a substantial portion of the high IRRs being reported by buyout funds is due to financial engineering and the availability of equity-replacement debt. Dividend recaps are permitting equity investors to take some or all of their capital off the table, reducing their capital at risk and leveraging up their reported rates of returns. But it should be noted that whereas dividend recaps raise IRRs, they don’t necessarily add to investors’ dollar profits. (And if they increase the total leverage on portfolio companies, they can jeopardize the recovery of any remaining investment.) Let’s say a fund buys a company for $200 expecting to make $40 in a year, for a 20% IRR. Assume a wacky capital market immediately lets the company borrow and dividend out $180 through a dividend recap. Now the fund’s invested capital is down to $20, and the $40 expected profit represents an IRR of 200% instead of 20%. The reported return is beautiful, but the fund’s expected gain is still just $40. Dividend recaps increase fund investors’ wealth only if the amounts dividended out can be reinvested profitably. Short of that, they represent financial engineering but not value creation. That – among other things – is the reason why I’ve titled this piece “You Can’t Eat IRR.” A high internal rate of return does not in and of itself put money in one’s pocket.

That implies a “conversion premium” of $200, or 25% of the $800 conversion value. The arbitrageur buys the bond and shorts the stock. If the stock goes up (producing a loss in the short position), he expects the bond to go up almost as much (producing a gain in the “long” position). If he has more money invested in the bond than he does in the short position on the stock, the result can be reasonably attractive. If the stock goes down (producing a gain in the short position), he expects the bond – buoyed by the income and the promise of redemption at maturity – to go down substantially less (producing a smaller loss in the long position), for an overall result that is very positive. The arbitrageur hopes for a reasonable mix of appreciating stocks (with decent results on the arb positions) and declining stocks (with highly attractive results), and he has the ability to use leverage to magnify this steady flow of modest profits. In addition, he receives more income on the converts he owns than he owes on the stock he’s short. It’s hoped that the above elements will combine to produce a consistently positive return. Obviously, the open question is how many shares to short in order to create the desired performance pattern. Because the relationship between the market price of the convertible and the market price of the shares isn’t constant, figuring out how much stock to short against a given bond purchase – the “hedge ratio” – has its vagaries.

Everyone knows there’s too much money looking for a home in buyouts, venture capital, distressed debt, hedge funds, real estate, and on and on. But that isn’t keeping more from flowing there. I love that terrific Yogi-ism: No one goes there anymore; it’s too crowded. But the corollary is appropriate for the alternative investing world of today: Because it’s so crowded, everyone wants to go there. Buyouts represent a great case in point today. It’s a simple business (execution aside). You buy a company with a little equity and a lot of debt. If you buy it right, if you can make it a better company, and if you run into an environment characterized by a strong economy, freely available capital and rising asset prices, you’ll be able to sell it for more than you paid for it, pay off the debt and enjoy a leveraged return. The theory is clear, but (like everything else in the investment world) it doesn’t always work. It worked very well from its inception around 1973 to roughly 1985, a period in which it was cheaper to buy a company through the stock market than start it and no one had ever heard of Henry Kravis. Then LBOs became enormously popular in the late 1980s, and companies were bought at ever-higher prices and ever-higher leverage ratios. Many of those went bankrupt in 1990 (causing a boom for distressed debt investors, but that’s another story). That’s what we call a full cycle.

© Oaktree Capital Management, L.P. All Rights Reserved Then a new cycle began, as it always will. Because the market was depressed in the early 1990s, as were investors, companies could be bought cheap again. And with both borrowers and lenders chastened, no one had to worry about deals becoming over- leveraged. When a lengthy economic recovery ensued, those deals did well. (Even in the next heyday for distressed debt investors – 2002 – very few buyouts went bad.) But every trend eventually is carried to excess, and it’s absolutely inevitable that “what the wise man does in the beginning, the fool does in the end.” So now everyone thinks buyouts hold the answer again. Everyone’s emboldened rather than chastened. And everyone’s enticed by the recent returns, which in many cases have been eye-popping. What’s been happening? Simply put, the stars have been perfectly aligned for buyout success. In the recession, the scandals and the stock market malaise of the early 2000s, companies could again be bought reasonably. Lenders became motivated to put out capital, so higher leverage could be piled on at low interest rates. The economy turned strong, and business recovered. As increased capital flowed to buyout funds, the competition to buy companies – even from other buyout funds – drove up prices. And most crazily, lenders became willing to extend debt capital so that equity sponsors could take out their investment in short order.

Nothing could be better for buyout returns than the ability to minimize your equity investment, increasing the extent to which returns are geared up. Thus the deals made in the last year or two have produced great returns. But that doesn’t mean the returns on deals made today and tomorrow will be similarly high. Will the favorable trends continue, or will they reverse? Will companies be costlier? Will interest rates rise? Will the economic environment continue to be salutary? Will leverage have the effect of magnifying gains or losses? Will the mega- fund managers do as well with $10 billion funds in the environment of tomorrow as they did with $3-6 billion in the past, with the stars aligned beautifully? No one knows the answers, but investors should be asking these questions. I recently had a visit from the head of one of America’s largest pension funds. He agreed with me that money is flowing to buyouts (and other forms of alternative investment) mainly because no one wants more mainstream stocks and bonds. He also pointed out that people are making these investments to capture the “illiquidity premium.” The illiquidity premium and its cousin, the risk premium, are return increments that illiquid and risky investments should deliver to compensate for their illiquidity and riskiness. If return premiums couldn’t be expected, investors wouldn’t make those investments.

© Oaktree Capital Management, L.P. All Rights Reserved operating profits change more than revenues) and financial leverage (such that net income changes more than operating profits).  The credit cycle moves dramatically, usually oscillating between periods when the capital markets are wide open and periods when they’re slammed shut.  The market cycle reacts violently, as investor psychology magnifies all of the above. Security prices yo-yo in what can often be described as extreme over-reaction. Everyone’s aware of these cycles and their influence on the markets, but it’s important that their essence and origin be thoroughly understood. For me that means delving into human nature and emotion. The theme of this memo will be that the cyclical phenomena that so heavily influence our investment outcomes aren’t caused by the operation of institutions or physical laws. Rather, they largely result from people’s frailties and excesses. A thorough understanding of these things can increase an investor’s ability to achieve gains and avoid losses. 1BUGreed or Fear When I was a rookie analyst, we heard all the time that “the stock market is driven by greed and fear.” When the market environment is in healthy balance, a tug-of-war takes place between optimists intent on making money and pessimists seeking to avoid losses. The former want to buy stocks, even if they have to pay a price a bit above yesterday’s close, and the latter want to sell them, even if it’s on a downtick.

© Oaktree Capital Management, L.P. All Rights Reserved It was in the mid-Seventies that I first began to hear of hedge funds such as Cumberland Partners and Steinhardt, Fine and Berkowitz. At that time the hedge fund industry consisted of a handful of funds trying to earn superior returns with total capital of a billion dollars or so. The funds limited their capital; researched smaller companies in greater depth than the mainstream investors; concentrated their portfolios in a handful of good ideas; and used shorting and hedging (but not leverage) to shape the pattern of their returns. For better or worse, their success over the ensuing 30 years led to fame and widespread emulation. As a result, we now have thousands of funds trying to earn superior returns with roughly a trillion dollars, and with much more on the way. (On September 13 The Bank of New York predicted that U.S. institutional investors alone would plow an additional $250 billion into hedge funds by 2008.) Can it still work? I hope you’ll permit me one of my tortured analogies. Have you seen the nature film on TV showing big fish eating? One of the big fellows rips a piece from his prey and moves through the water enjoying his dinner. But due to his poor table manners, he spews small crumbs as he goes. It’s for this reason that each big fish is trailed by a hundred little fish. They snack on the scraps he drops, enjoying his leavings. He does the hard work, and they get a free lunch.

Well that’s the way I’ve always thought of the investment world. Mainstream institutional investors emphasize the big asset classes and follow the big companies, creating a relatively efficient market and a context for relative valuation. But their attention wanes as the targets shrink, and their hands are tied by constraints on their behavior. Little guys such as hedge funds operate in the interstices. They take advantage of small inefficiencies and misvaluations that the big guys create, permit or ignore. They pursue things that are unseemly, esoteric or highly labor intensive. And they can employ tactics like leverage and shorting – and live with levels of portfolio concentration and illiquidity – that aren’t tolerated in the mainstream investment world. In other words they, too, benefit from the big guys’ leavings. The critical question is obvious: How many little fish can thrive in the shadow of each big fish? A hundred little fish trailing each big one all can do well. But those crumbs won’t feed five hundred. Not only will the crumbs be insufficient in number, but the crowd will fight over them in a way that’s unhealthy for everyone. Tortured enough? Maybe so, but I think the analogy holds. In my time in this business, the institutions have been the big fish of the investment world, and the hedge funds and alternative investment specialists have profited from their biases and limitations.

The real question is whether there are enough inefficiencies in this universe for all of the would-be hedge funds to invest in, and whether the presence of a large and growing number of funds has a deleterious effect on the adequacy of the supply. Of course, it goes without saying: just as no asset class has the birthright of a given return, giving something the overly broad label of “hedge fund” – and paying its manager “two-plus-twenty” – won’t make it a stellar, or even a steady, performer. UThe Hedge Fund Manager’s Superior Arsenal A great deal is made of the powerful tools at the hedge fund manager’s disposal. The ability to employ leverage – often in unlimited amounts – and the absence of constraints on investment tactics are lauded for their potential to add to results. But no one should forget their potential to do the opposite as well. Almost every weapon in the investment arsenal is a two-edged sword. The only exception is genuine, sustainable personal skill. Everything else will make you money when it works but lose you money when it doesn’t. Leverage and free rein are no exceptions. Being able to leverage a portfolio means being able to invest a multiple of your equity capital. Why should an investor with $1,000 be content making $100 on a price rise of 10%? Why not borrow another $3,000, invest all $4,000 in the same assets, and make $400 on a 10% rise? All you need is access to 3-to-1 leverage . . . oh yes, and the ability to identify assets that appreciate.

© Oaktree Capital Management, L.P. All Rights Reserved In Vegas they say, “the more you bet, the more you win when you win.” Although the logic of this statement is impeccable, it omits the obvious addendum “. . . and the more you lose when you lose.” Leverage is not a source of alpha; it’s a way of increasing your exposure to a given amount of alpha . . . or lack of alpha. The 3-to-1 leverager described above will lose 40% of his equity if prices go down 10% instead of up. The ability to use leverage – which is high and rising today given the low cost of money and the lure of the “carry trade” – certainly doesn’t add asymmetrically to investment results. Neither does freedom from constraints. Institutional investors usually spend lots of time negotiating what tactics a mainstream investor will be permitted to apply and crafting contracts to keep him from straying afield. Then they turn over a bunch of money to a hedge fund manager and say, “do as you please.” (I exaggerate for effect.) Does that make sense? Only in one case: where the manager possesses great skill and discipline. Investment constraints (1) enable clients to know what style of management they’ll be getting and (2) hopefully limit managers to what they’re good at. Their absence sets the stage for surprises and permits managers to wander into areas where they may have less skill. Thus the results from unrestrained hedge funds are often unforeseeable, and these vehicles should be handled with care.

I think investors should pay above average fees only for asymmetric value added – that is, for a potential increment to returns that isn’t accompanied by a corresponding potential decrement. And I think only genuine skill adds asymmetrically to investment results, not leverage and not the mere ability to use a wide range of investment tactics. The key in hedge fund investing is finding managers who have that skill. It isn’t ubiquitous. UA Few Words on Performance Frankly, I wonder whether the decision to invest in hedge funds today is fully supported by their performance in 2000-04, their period of great popularity. I’ve watched institutions decide to join hedge funds. I think most of them invested for “absolute returns” – which I believe were supposed to be in the high single digits after fees – accompanied by low volatility and limited correlation with the mainstream markets. Now most institutions seem to be satisfied with their hedge fund performance and are signing up for more. But I wonder whether they should be. For the purposes of the analysis below I’ll use the CSFB/Tremont Hedge Fund Index.  With the S&P 500 down 9%, 12% and 22% in the 2000-02 bear market, investors in the CSFB/Tremont Index’s average fund were delighted to make money, with the Index returning 4.9%, 4.4% and 3.0% in those years, respectively.

Holders of assets, who play a part in setting market prices by deciding where they’ll sell, also are optimistic. The result is an unappetizing, risk-tolerant, high-priced investment landscape. It’s for times like this that my favorite Warren Buffett quotation is most appropriate: “The less prudence with which others conduct their affairs, the greater the prudence with which we must conduct our own affairs.” UImplications for Investing One way to improve investment results – which we try hard to apply at Oaktree – is to think about what “today’s mistake” might be and try to avoid it. There are times in investing when the likely mistake consists of:  not buying,  not buying enough,  not making one more bid in an auction,  holding too much cash,  not using enough leverage, or  not taking enough risk. I don’t think that describes today. I’ve always heard that no one awaiting heart surgery ever complained, “I wish I’d gone to the office more.” Well, likewise I don’t think anyone in the next few years is going to look back and say, “I wish I’d invested more in 2004.”

© Oaktree Capital Management, L.P. All Rights Reserved Rather, I think this year’s mistake is going to turn out to be:  buying too much,  buying too aggressively,  making one bid too many,  using too much leverage, and  taking too much risk in the pursuit of superior returns. There are times when the investing errors are of omission: the things you should have done but didn’t. Today I think the errors are probably of commission: the things you shouldn’t have done but did. There are times for aggressiveness. I think this is a time for caution. Not every investor has the option of holding a lot of cash. A pension fund has to pursue its actuarial return, and too many years spent earning money market rates can ensure it won’t be achieved. The same can be true for a foundation that has to spend 5% of its assets each year, and for an individual living on his or her investment income. But when I look today at the smart people I know who have the ability to hold cash, I see large balances. As Warren Buffett wrote in his 2003 Annual Report, “Our capital is underutilized now . . . . It’s a painful condition to be in – but not as painful as doing something stupid.” There are times when big funds are a good thing – when the market power that comes with more money is a help. I think this is generally a time for moderation in fund raising – a time when the selectivity and agility that come with smallness will prove to be key.

© Oaktree Capital Management, L.P. All Rights Reserved  As has happened in other alternative investment fields, changes in an industry can expose weaknesses in the compensation arrangements. Originally, management fees were intended primarily to cover operating expenses while incentive fees motivated managers to strive for profits. But as funds grow larger, some are at the point where managers can get rich on management fees alone. Recently we’ve seen investment celebrities start hedge funds with perhaps $3 billion of capital and management fees of 2% or so. $60 million a year is a pretty good start if you can get it. Fees like these can motivate managers to put a higher priority on perpetuating the management fee machine than on pursuing portfolio gains. Although hedge funds and private equity funds carry similar fee arrangements, the latter have hurdle rates that motivate their managers to try for double-digit returns. Hedge fund managers probably figure they can hold onto their capital and earn 2-4% a year for themselves with returns in moderate single digits. I’m not sure that warrants the fees.  At the other end of the spectrum from managers able to attract billions in capital and massive management fees, the impatient newcomer with access to incentive fee money faces potential temptation that also might trouble investors: It makes perfect sense for him to start a fund and swing for the fences with highly risky securities, leverage and concentration.

© Oaktree Capital Management, L.P. All Rights Reserved It’s in this way that the swing of the capital market pendulum to one extreme provides the energy for the swing back toward the other. For example, with terrified high yield bond investors hugging the sidelines in 1990-91, low issuance and a great degree of investor selectivity set the stage for low subsequent default rates and excellent portfolio performance. Double-digit returns in 1991-97 (save 1994) turned investors from cautious to confident and attracted increased capital for investment in high yield bonds. These conditions led to the issuance of bonds in greater quantity and lower quality in 1997-99. And, of course, that issuance contributed to record default rates in 2001-02, to great portfolio losses, and eventually to enormous returns on the rebound. And so the cycle goes on. From the depths reached in the summer of 2002, the recovery of investor sentiment has been dramatic in both its extent and its speed. And with that recovery has come yet another dramatic swing of the capital cycle from restrictive to accommodating. Again as seen through the example of high yield bonds, the last eighteen months have witnessed a near-record amount of new bond issuance, including a large number of CCC-rated bonds, bonds with weak covenants, and bonds issued to fund payments to equity holders. All net debt incurrence adds to a company’s riskiness, in that it increases balance sheet leverage.

© Oaktree Capital Management, L.P. All Rights Reserved adjusted returns, it’s not likely to be by doing the same things everyone else is doing. The best and most safely earned profits are apt to be found outside the mainstream, not inside. The most important thing is being leery of leverage. The key elements in Oaktree’s investment approach include focusing on what’s out of favor; ascertaining intrinsic value and trying to buy for less; and adding value by working with assets once we own them. If done well, these things can simultaneously increase prospective return and reduce risk. Leverage, on the other hand, increases prospective return and UincreasesU risk. There’s nothing magic about leverage. It increases upside potential, but it also reduces or eliminates the margin of safety. Leverage is just an application of the Las Vegas maxim, “The more you bet, the more you win when you win.” But I think people tend to omit “. . . and the more you lose when you lose.” As Warren Buffett puts it, “It’s a very sad thing. You can have somebody whose aggregate performance is terrific, but they have a weakness – maybe it’s alcohol, maybe it’s susceptibility to taking a little easy money – it’s the weak link that snaps you. And frequently, in the financial markets, the weak link is borrowed money” (emphasis added).

At Oaktree we believe it may be okay to use leverage to take advantage of unusually generous profit opportunities, but it’s dangerous to use leverage to try to wring big returns out of small profit margins. The most important thing is acknowledging the impact of uncontrollable factors. Defensive investing, insistence on value, and shying away from leverage -- they’re all important. And much of the reason they’re important stems from the fact that so little of short-term performance is under our control. Clients say, “We expect you to be in the top quartile after x years.” What can we do to satisfy those marching orders?  We can try hard, but we don’t do any more for the client who wants top quartile performance than we do for the one who wants us to be above the median.  We can put together the best portfolio we can, but doing so will have only limited impact on our relative performance. How we perform in relative terms will depend largely on what our competitors do.the

It wanted to avoid consolidation with its own financial statements, but it feared that vigilance on the part of outside investors would prevent Enron from doing all it wanted in the partnerships. Investors with capital at risk would care about how much debt was taken on, what the partnerships bought with the borrowed money, and at what prices. They might even worry about having Enron executives running the partnerships, which did business with Enron. So outside equity capital had to be attracted to satisfy GAAP, but truly self-interested investors had to be avoided if Enron was to maintain its flexibility. How could outsiders be enticed to invest capital without caring? Simple: guarantee the results. The key was for Enron, not the investors, to absorb the risk. This is accomplished by promising a full return of capital, and returns up to 30% a year in some cases, and backing the promise with Enron stock. Certainly the security provided by this investment-grade company's soaring stock would be solid. Enron also guaranteed some of the loans to these entities. So with the "outside" investors' risk covered by Enron and the "independent" partnerships squarely under its control, they could be used any way Enron chose. When assets declined in value, the partnerships would buy them at Enron's cost, hiding the losses. When profits seemed likely to disappoint in a quarter, assets could be sold to the partnerships at inflated prices, covering the shortfall.and

 An investor may take an appropriately cautious stance – let’s say toward tech stocks in 1997 or residential mortgage backed securities in 2005 – only to see an irrationally overpriced market become more so, as prices soar for years. He looks terrible, a victim of the old adage that “being too far ahead of your time is indistinguishable from being wrong.”  Further, in a special case of being wrong as to timing although perhaps not fundamentals, an investor may take a concentrated position in a laughably underpriced stock, using a huge amount of borrowed money. But before the expected appreciation can take place, a market crash brings on a margin call, and he’s wiped out. As John Maynard Keynes said, “The market can remain irrational longer than you can remain solvent.”  Last year marked the passing of Joe Granville, a technical analyst whose warning in 1976 was followed by a 26% two-year decline, winning him respect and fame. But his next accurate call wouldn’t come for 24 years, when he told people to sell tech stocks in 2000. Was it skill back in 1976, or a lucky call that turned out right when events went his way? Regardless, he became one of many in the investment business who get famous for having been “right once in a row.” © OAKTREE CAPITAL MANAGEMENT, L.P. ALL RIGHTS RESERVED.

© Oaktree Capital Management, L.P. All Rights Reserved. The first thing I remember learning at Wharton in 1963 was that the correctness of a decision can’t be judged from the outcome. Because of the randomness at work in the world and the unpredictability of the future, lots of bad decisions lead to good results, and lots of good decisions end in failure. In other words, for an investor to both be right and make money:  his view of what will happen in the future – and what should be done about it – has to be analytically correct a priori,  the things he thinks will happen have to actually happen, and  those things have to happen on schedule. But in investing, it’s hard to know what will happen and impossible to know when it will happen. Many things influence performance other than (a) investors’ hard work and skill and (b) the market’s dependable discounting of information about the future. Luck – randomness, or the occurrence of things beyond our knowledge and control – plays a huge part in outcomes. Investment success isn’t just a question of whether the investor put together the “right” portfolio, but also whether it encountered a beneficial environment. Thus being successful requires a significant degree of luck. No one gets it right every time. (That’s why even the best investors diversify, hedge and/or limit their use of leverage.) But the skillful investor is right more often, over a long period of time, than an assumption of randomness would permit.

High yield bonds have provided the foundation for much of Oaktree’s success and many of its subsequent initiatives. Ten years later, in 1988, Sheldon and I agreed with Bruce Karsh that we should organize our first distressed debt fund, and Bruce hired Richard Masson to join him in the task. While the prominence of Drexel Burnham and Michael Milken had attracted attention to high yield bonds by that time, distressed debt was still little known and poorly understood. What could be more unseemly and frightening than the debt of companies that were bankrupt or that appeared overwhelmingly likely to become so? No mainstream financial institutions invested in distressed debt or offered distressed debt funds, leaving an open playing field for us. Bruce’s aggregate since-inception return of 23% per year before fees (17½% after) – without the benefit of leverage – certainly suggests that inefficiencies have been present. And the fact that he has earned that return over 25 years while investing $35 billion says it wasn’t luck. My point here is that these markets – and others that Oaktree entered over the years – have been inefficient markets. The lack of information, infrastructure, understanding and competition created many opportunities for us to find bargains, and for our clients in those markets to enjoy favorable returns with less-than-commensurate risk. The Durability of Inefficiency If efficiency should be the going-in presumption, so should “efficientization.

It can best be described as "degree of responsiveness" to the market, or "relative volatility." An S&P index fund will have a beta of 1.0 relative to the S&P 500 (that is, it will go up and down at the same rate as the S&P). An S&P index fund leveraged two to one would have a beta of 2.0 (i.e., it will have twice the response). A portfolio consisting of half S&P index fund and half cash will have a beta of .5. A defensive equity portfolio might be expected to have a beta of .7. Turning up your beta, whether through the use of leverage or by emphasizing more volatile holdings, is certainly one way to try to add to your return. Under investment theory it's the only way, since "beta x the market's return" is the only non-zero term in the above equation (more on this later). The trouble with relying on a high beta to enhance your return is that it's entirely symmetrical. It cuts both ways, subtracting as much when it's wrong as it adds when it's right, which means that it does nothing to increase your expected return unless the underlying decisions are right.Vegas

By purchasing undervalued bonds and selling short overvalued bonds affected by similar factors, gains would be earned consistently and without exposure to market risk. The intellect and accomplishments of Long-Term's managers, and its strong annual returns, compelled investors to invest and freed them from feeling they had to understand exactly what the fund did. The fund's approach may not have been fully delineated to investors, its portfolio was never disclosed, and the managers' actions were not even reported after the fact; 40% annual returns were enough to keep investors satisfied. You've probably heard us say that bond investing is a game of inches. So then how was Long- Term able to earn returns of 40% or more most years? The answer was leverage: they borrowed enough money to buy bonds worth many times their equity. It is now known that Long-Term's general partners' cash equity was increased through borrowings to roughly $1.5 billion and paired with $3.1 billion of limited partners' capital. This $4.6 billion of equity was somehow sufficient to enable Long-Term to hold investments totaling about $150 billion and long and short positions in derivatives believed to have had an aggregate "notional value" of $1.25 trillion!

Assumedly, Long-Term used models to assess the probability of history reasserting itself and the risk to the overall portfolio of individual relationships going the wrong way. Thus would they determine the amount of risk and leverage that could safely be taken on. In his wonderful book, Against the Gods, Peter Bernstein shows how development of the study of probability made possible both informed gambling and informed investing (along with other forms of decision making concerning the future). But the products of this pursuit remain mere probabilities, or reasonable expectations. Likely events sometimes fail to occur, and unlikely events sometimes do. Or, as my friend Bruce Newberg says when I get the one improbable roll of the dice needed to beat him in backgammon, “there can be a big difference between probability and outcome.” If you are conscious of the difference between a likely outcome and a certain one, you may not want to bet the ranch. The same is true in the world of investments; put simply, relationships that are supposed to hold sometimes fail to do so.

Not only is it insufficient to enable those possessing it to control the future, but awe of it can cause people to follow without asking the questions they should and without reserving enough for the rainy day that inevitably comes. This is probably the greatest lesson of Long-Term Capital Management. There are others, which I'll review below. 1) As I've written before, "volatility + leverage = dynamite." The main cause of Long-- Term's collapse probably wasn't its security selection, or the declines in its markets, but rather its leverage. On average, its positions may have declined just a few percent. But when your assets exceed 25 times your equity, even a 4% price decline is enough to wipe you out. Nowadays, most people use the word "leverage" interchangeably with "debt." But it's better understood in the sense I first learned: the extent to which a change in the top line is magnified by the time it reaches the bottom line. That's why the British call it "gearing." In Las Vegas they say “the more you bet, the more you win when you win.” They never add "… and the more you lose when you lose.” Leverage is just a way to let you bet more than your capital, and it exposes you to more of the good and more of the bad. Leverage can truly be dynamite. None of Oaktree's portfolios use leverage to invest more than our capital (although our Emerging Markets Fund will be able to do so to a limited extent).

We have reviewed several opportunities for leverage, but in the risk-tolerant climate prevailing until recently, we didn't find base returns worth leveraging up. For example, despite repeatedly being invited to do so over the last five years, we declined to organize CBOs (leveraged high yield bond portfolios). This followed from our conviction that leverage should never be used in an attempt to turn low spreads into wide ones, only to take advantage of already-wide spreads. The managers of Long-Term used enormous leverage in an attempt to profit hugely from minute spreads, and it eventually did them in.

This old saw goes out of style from time to time, but it makes a comeback each time a get-rich-quick scheme is exposed. Many "riskless" arbitrage, hedge and market-neutral strategies have turned out to involve more risk than was let on. When I was a kid, I saw in a 1930s movie that the Rothschilds built their fortune because their exclusive use of carrier pigeons allowed them to simultaneously buy a currency at one rate in London and sell it at a different rate in Paris. That's pure arbitrage: trading the same asset at different prices at the same time. But as soon as you deal in different assets that have less than a 100% probability of moving in tandem, you introduce “basis risk,” or the risk that the assets being arbitraged won't go in the anticipated directions. That's what killed Long-Term; their bonds' yields diverged when they were supposed to converge. Historic relationships proved to be less dependable than had been thought. 4) “ It's always something.” That's what Roseanne Rosanadana used to say on Saturday Night Live, and it's very true -- eventually, something always goes awry. Any course of action which depends on everything going right is unsafe, but such an expectation has to have been behind Long-Term’s 25-plus times leverage.

© Oaktree Capital Management, L.P. All Rights Reserved In times of easy money, companies prosper that should not, just as deserving companies fail when money's tight. Easy money was key in Long-Term's early success and later collapse. The bankers and brokers let the General Partners lever up their equity capital and take on far out-sized positions. They loaned amounts of money that were unsafe both for Long-Term Capital and for themselves. I assume that, seduced by Long-Term's brilliance, they did so without knowing how much it had borrowed in total or what its portfolio looked like. The violent swings of the credit cycle -- usually far more volatile than the underlying economy -- are behind many of the extreme occurrences in the business and investment world. Excessive lending contributed greatly to booms preceding the collapses in real estate in 1989-92 and emerging markets in 1997-98, just as tight lending added to the bankruptcies of 1990-92. Look around the next time there's a crisis; you'll probably find a lender. 7) “How Quickly They Forget.” While it would be great (and very profitable) to be able to see the future, the truth is that few of us can. But you don't have to be prescient to be able to invest intelligently while avoiding the most dangerous hazards. Knowledge of the past will get you a good part of the way there. The relevance of the lessons of Long-Term has nothing to do with knowledge of the future. Leverage is always dangerous.

© Oaktree Capital Management, L.P. All Rights Reserved - the domestic investor looks overseas, - the international investor emphasizes emerging markets, and - the traditional bond-and-stock investor searches for "alternative investments" likely to repeat the success of the LBO and bankruptcy funds. And why shouldn't they? The "stick" is the low prospective return offered in each investor's traditional bailiwick, and the "carrot" is the high returns earned recently in the riskier sectors. In brief, "why should I settle for 3% in T-bills when I can get double-digit returns in stocks?" There are numerous signs of infatuation with -- or non-questioning acceptance of -- the pursuit of high returns. The torrential inflow of dollars to mutual funds is one; I recently attended a conference at which a fund group representative said they were taking in $100 million a day, 90% of it for foreign funds. The rising level of margin debt is another. Books on investing are reaching the best-sellers list. The names of hedge fund managers are almost household words. And that brings me, for purposes of illustration, to the subject of hedge funds. When I first got to know the money management community twenty years ago, only a handful of managers were good enough to command a share of the profits as compensation. Today, according to a recent article in Forbes, there are 800 hedge funds, and some people think being accepted by one of the big names is the chance of a lifetime.

© Oaktree Capital Management, L.P. All Rights Reserved - As an experienced corporate director told Forbes a few years ago, "I no longer expect people to do what I tell them to do; I've learned they only do what I pay them to do." But while a hedge fund manager may have his reputation and some capital at stake, as to fees he is in a heads-we-win-tails-you-lose position. For a manager who is paid a percentage of the profits on a one-year- at-a-time basis, a single year of investing aggressively enough at the right time can make him rich for life. Thus managers should be entrusted with incentive fee arrangements only if they can truly be counted on to add significant value which is UnotU accompanied by proportionate risk. - Volatility + leverage = dynamite. Only now do we see articles pointing out (after the fact) that if a hedge fund borrows short to buy long Treasury bonds with 6% "down," a 1% rise in the bonds' yield will wipe out 100% of the equity in the position. - When volatile securities have been bought on margin, sale may be forced if the investor can't come up with more capital during a decline. This is a big part of what put the Granite Fund under. If you own securities without borrowing, you may experience a price drop -- which will hopefully prove temporary -- but you can't be put out of the game. - One characteristic of many inefficient markets is some measure of illiquidity.