Onex Corporation (OTCPK:ONEXF) Q3 2020 Earnings Conference Call November 13, 2020 11:00 AM ET
Jill Homenuk – MD, Shareholder Relations and Communications
Anthony Munk – Vice Chairman
Chris Govan – Senior Managing Director and CFO
Bobby Le Blanc – Senior Managing Director
Conference Call Participants
Nick Priebe – CIBC
Geoff Kwan – RBC Capital Markets
Scott Chan – Canaccord Genuity
Welcome to Onex Third Quarter 2020 Conference Call. During the presentation, all participants will be in a listen-only mode. Afterwards we’ll conduct a question-and-answer session [Operator instructions] As a reminder, this conference is being recorded.
I would now like to turn the conference over to Ms. Jill Homenuk, Managing Director, Shareholder Relations and Communications at Onex. Please go ahead.
Thank you. Good morning, everyone, and thanks for joining us. We’re broadcasting this call on our website. Hosting the call today are Bobby Le Blanc in his first shareholder call since being named Onex President in August; and Chris Govan, our Chief Financial Officer. Other members of the team are joining for the Q&A session.
Earlier this morning, we issued our third quarter 2020 press release, MD&A and consolidated financial statements, which are available on the Shareholders section of our website and have also been filed on SEDAR. Our supplemental information package is also available on our website. As a reminder, all references to dollar amounts on this call are in U.S. unless otherwise stated. I must also point everyone to our webcast presentation for our usual disclaimer and cautionary factors relating to any forward-looking statements contained in today’s presentation and remarks.
With that, I’ll now turn the call over to Bobby.
Bobby Le Blanc
Good morning. Thank you for joining us, and welcome, Jill, to your first Onex shareholder call. Onex reported net earnings in the third quarter of $501 million or earnings per share of $5.29. Net earnings on a segmented basis were $515 million or $5.39 per share. Overall, it was a very good quarter for Onex in an operating environment that continues to adapt to the evolving COVID-19 situation.
Investing capital per share grew 11% quarter-over-quarter and is now 8% higher than where it was at the end of 2019. This increase reflects the strength and diversification of our investment platforms, a continuing recovery in both our PE and credit portfolios as well as the attractive investment we’ve made in buying back our shares. Across all Onex platforms, we are executing on targeted strategies, setting us up well for strong future investment and financial performance.
We are focused on value generation for our shareholders, limited partners and clients who invest with us. I’ll now provide some highlights from each of our business segments. Within private equity, we are actively working with our companies while continuing to look for opportunities to create value and deploy capital where we see long-term growth potential, particularly in our core verticals.
This quarter, OP IV extended its recent momentum, ending the period with a net IRR of 7%. We are steadily approaching the threshold, but we’ll start earning value from carried interest. This quarter’s progress was driven by strong performance at our public companies as well as Parkdean and PowerSchool. OP V deployment is on pace at 43% invested with two recently announced investments, both in areas leveraging Onex’ sector strengths.
In October, we announced a pending majority investment in OneDigital, a market-leading employee benefits insurance broker for small and medium-sized businesses in the U.S. OneDigital operates in an industry that we know well, and we are impressed with management’s ability to continually grow. This transaction is expected to close in Q4. Similarly, in September, we closed on our acquisition of Independent Clinical Services.
ICS is another good example of Onex investing in a sector where we have broad and deep experience, targeting a business with a strong and proven value offering. Turning to our team. We are pleased to announce the promotions of Nigel Wright and Tawfiq Popatia to Senior Managing Directors of Onex Partners in recognition of their investing track record, leadership qualities and long-standing contributions.
Congratulations to both of them. Before moving to our credit business, I wanted to touch quickly on our travel, events and leisure investments. All of these businesses have made tough but necessary decisions in recent months to reduce their operating costs and improve their liquidity during a period of unprecedented uncertainty caused by the global pandemic. We are grateful for their efforts and remain confident in their prospects as conditions recover.
In our credit business, growth areas that we identified pre COVID, including opportunistic credit, have increased in relevance with the current market environment. We have made a number of senior hires, and we’ll continue to have select hiring in targeted areas, contributing to future AUM growth. The margins of the credit business will be muted as we build out the team. However, as our AUM grows in this segment, you should expect to see our margins improve substantially.
Credit markets continue to recover in the third quarter, with both the high-yield and leveraged loan indices recouping almost all of their losses from the first quarter. Contributing factors to this recovery were the continued monetary and fiscal support, solid earnings from issuers in both markets as well as investors searching for income due to lower investment-grade and government bond yields. Onex Credit continues to add new investors across strategies. Recently, we priced our 20th U.S. CLO, and the transaction was supported by a diverse global group of more than 20 investors, including three new equity investors.
Almost two thirds of the CLO equity was taken up by third-party investors, which meaningfully improves Onex’ all-in return on capital. Our wealth management team at Gluskin has also been investing for the future. Just as we’ve added new capabilities by hiring new team members, we continue to deliver increasingly in-demand alternative strategies to our clients, thanks to our ability to leverage the broader Onex platform. Gluskin client allocation to Onex Credit strategies and private equity totaled $570 million by quarter end.
Onex Corporation’s balance sheet remains strong. As always, we maintain liquidity to fund future commitments while having the flexibility to be opportunistic and agile in other areas of deployment. This quarter, we returned more capital to shareholders through buybacks, repurchasing over 6.3 million shares at what we believe is a very attractive valuation.
While we remain in what is largely a work-from-home environment, our team continues to demonstrate the flexibility and entrepreneurial spirit that is core to Onex’ culture. I’m proud of how the team has adapted and also in how we’re supporting our communities.
Through Onex Cares, our employee-directed donation program, we’ve donated approximately $1.1 million to more than 130 charities since the start of COVID. In summary, Q3 was a good quarter for Onex, building on our momentum from Q2, and I feel confident in our team’s ability to deliver strong performance in a recovering economic environment. We do plan to provide additional details on our performance expectations across our platforms during our Q4 call as we look ahead to 2021.
With that, I’ll pass it to Chris for more on the financials.
Thanks, Bobby, and good morning, everyone. Onex reported net earnings of $501 million or $5.29 per share in Q3, bringing us into a net earnings position on a year-to-date basis at $133 million or $1.36 per share. Q3 segment earnings were $515 million or $5.39 per share and $152 million or $1.55 per share for the 9 months ended September 30. Our segment results were driven by our investing segment, which contributed $492 million this quarter.
Onex results in Q3 reflect both improved underlying equity and credit markets with the S&P 500 up nearly 9% and the CS Leveraged Loan Index returning over 4%, but also importantly, the strength and diversification of our underlying portfolios and the ability of our portfolio companies and their management teams to navigate market conditions. Let’s start by looking more closely at Onex’ PE portfolio.
Q3 included a net mark-to-market gain from private equity investing of $457 million. This gain represents a gross quarterly return of 14%, reflecting value increases across much of the portfolio. As was the case with the public markets in Q3, the value increases in our portfolio were broad-based. As a reminder, Onex’ PE portfolio is made up of 38 separate businesses with no cross-collateralization. This slide details the allocation of the portfolio by industry segment at the end of Q3.
Of these eight segments, five contributed double-digit returns in the quarter. The strong portfolio performance in the quarter was led by the business services segment, with a 24% mark-to-market gain in the quarter, contributing over $260 million to segment income. Additionally, our industrial portfolio companies continued their strong recovery from Q1 lows, led in the quarter by an increase in the share price for JELD-WEN as well as positive contributions across the entire industrials portfolio. You’ll notice that we’ve once again provided a breakdown of our PE portfolio by COVID exposure.
We continue to see strong value gains in the low to positive exposure category, by far the largest by value. This quarter, we also saw good performance in the demand/supply headwinds category, with the group now down only 11% year-to-date, and we’re seeing overall stabilization in the direct exposure group with value up 11% this quarter. Although there continues to be uncertainty across many sectors in the economy, particularly with the recent escalation of COVID cases in North America and Europe, we feel confident knowing almost 60% of Onex’ PE exposure continues to be in businesses where we believe the pandemic has either a low or positive impact.
The nearly $2.5 billion at work in these investments continues to provide Onex a meaningful hedge against COVID-related headwinds. Our credit investments had modest mark-to-market gains in the quarter following a big bounce back in Q2. For the first nine months of the year, our credit investments continue to be down about 11% on a mark-to-market basis relative to a 1% decrease in the CS Leveraged Loan Index, reflecting the structural leverage employed in our strategies.
In light of the COVID-related impacts on the underlying portfolio of loans, we no longer expect our current CLO investments to reach the low double-digit IRRs originally targeted. However, we do expect these CLOs to provide a meaningful positive return overall and certainly attractive forward returns from today’s marks. We continue to watch our CLOs’ exposure to CCC-rated loans and the resulting impact on the interest diversion test.
The underlying metrics continue to stay well above lows experienced at the end of April, and all our CLOs met the test for purposes of the upcoming Q4 distributions. Q3 also brought some early signs of the AUM growth expected from the meaningful investments we’ve made in the Onex Credit team this year. We completed fundraising for the Onex Senior Loan Opportunity Fund and launched a strategy focused on investing in third-party CLOs. Onex participated in both, committing $150 million in aggregate. We’re excited about the opportunity to deploy Onex’ capital alongside our limited partners in these new strategies, managed by a team with a strong track record in the space.
Overall, shareholder capital was down from December 2019 in absolute terms, but much of that decrease reflects $441 million used to repurchase Onex shares. On a per-share basis, shareholder capital was up over $4.50, driven by an 8% year-to-date increase in investing capital per share. The composition of Onex’ capital has remained relatively unchanged this year with private equity, credit and cash representing 63%, 10% and 26% of hard NAV, respectively, very similar to the allocation at year-end. The stable allocation was primarily the result of realizations from private equity being deployed to repurchase shares.
Year-to-date, realizations totaled just over $580 million from our private equity investments, primarily from secondary sales of SIG and Clarivate. And our credit investments returned $60 million, including $50 million of regular quarterly CLO distributions. On the investing front, we’ve put $325 million to work in attractive PE investments post COVID, including an incremental investment in RSG of $108 million as well as investments in Emerald and ICS via Onex Partners V.
Through Onex Credit, we put just over $110 million to work in the first 9 months of the year, including $55 million in CLOs and related warehouses as well as $47 million in the newly launched strategies I described earlier. Throughout Q3, we continued to buy back Onex shares at an attractive discount, driving incremental value for our continuing shareholders.
In total, during Q3, we utilized about $300 million to repurchase over 6.3 million shares at an average price of just under CAD 63 per share. Giving full value to our cash and publicly traded investments, our average repurchase price implies a discount to the private investments of about 55%, and that’s without giving any value to the asset manager. The discount in which we bought back the shares immediately benefited our continuing shareholders, resulting in a 2% increase in investing capital per share in the quarter. On a year-to-date basis, our share buybacks resulted in a 4% increase in investing capital per share.
Lastly, before turning the call over to Q&A, I’ll spend a few minutes on the asset and wealth management segment. It generated net earnings of $23 million or $0.22 per share in Q3. The year-over-year increase in net earnings was driven by PE and in particular, a net improvement in carried interest income on a mark-to-market basis of $34 million. This was partially offset by a reduction in PE management fees, which trended down as realizations reduced the fee basis in our fully invested funds.
As Bobby mentioned, OP IV is getting very close to the threshold to generate carried interest, and with $3.6 billion of LP capital, carried interest from OP IV could be a meaningful contributor to segment earnings in the coming quarters. Contributions from our credit manager and the wealth management business were both impacted this quarter by continued investment in strategic growth, which we expect to benefit future segment earnings. The credit manager contributed $1 million in Q3, continuing to reflect upfront investments we’re making to build out the team and position the platform to meaningfully grow outside of CLOs and senior loans.
As we raise fee-paying capital across these new strategies, we expect credit’s profit margin to trend towards historical levels. In wealth management, the net contribution decreased by $6 million year-over-year. In addition to investments made, earnings were impacted by lower AUM as well as lower management fees as we continue to align rates to be more competitive.
On an LTM basis, asset and wealth management segment earnings increased by $29 million year-over-year or $0.29 per share. This was primarily driven by the full year contribution from Gluskin Sheff and a lower net reversal of carried interest. Looking forward, Onex’ run rate annual management fees are $294 million; $183 million from private equity, $59 million from Gluskin’s public equity and debt strategies and $52 million for Onex credit.
We’d now be happy to take any questions.
[Operator instructions] Our first question comes from the line of Nick Priebe from CIBC.
Okay. I just wanted to go back to the buyback discussion. I think you’ve repurchased about 10% of your stock year-to-date. The average price has been in the low $60 range. So is the inference there that we should expect this pace of buybacks to continue? Or would you become constrained at some point based on either your commitment to the fund or targeted cash balance at the corporate level?
Bobby Le Blanc
Anthony, you mind handling that one?
Sure. So the governor on our share purchasers — purchases are dictated by the rules regarding the TSX buyback in terms of percentage of float. We have the ability to buy back 10% of our float in any given year. As you may recall, the commencement of our NCIB is April 17. That’s when we renew our bid for the year, and it’s outstanding for the whole year from that point. And so we are limited beyond what we’ve purchased today to approximately just under 600,000 shares. And then come next year, we’ll renew it again and will be subject to the rules then for the following 12-month period. So that’s essentially how you should think about it.
And just going back to the investment returns in the credit business. I think Chris, you indicated that your returns on CLO equity are no longer expected to achieve that low double-digit return that you’d initially targeted. So what are you modeling or expecting internally there? How big should we expect the variance to be relative to that previous target?
Yes. Nick, I think where we’re headed is expecting kind of ultimate returns from that portfolio to be now in the mid- to high single digits, so sort of think 7%, 8% based upon our current modeling and our current marks versus that 12% that we would have originally targeted and modeled across that portfolio. And of course, as you know, that’s just purely the return on the equity investments. When you think about the return on the capital, including the fees, it’s obviously much more attractive than that.
Got it. Okay. And then what about the performance of the credit platform on a relative basis? Like it looks like the default rate has predictably increased in the leveraged loans market. I presume there’s been a concentration of default in spaces like energy and retail, which I think you’ve avoided in the past. Can you just give us a read on the relative performance of your credit strategies through the stressed environment?
Sure. I think the best way to think about that really is the performance of the underlying CLO portfolio. And I think interestingly, this ties into the lower returns on equity to some extent. We had, I think, a very well-managed and relatively creditor-friendly portfolio, which is part of the reason our equity returns have been dampened, but it wasn’t as aggressive a portfolio as perhaps some others.
So there are industry rankings out there for CLO managers. And when you look at that — those rankings, like today, Onex Credit is in the second quartile in terms of the percentage of their portfolio that’s rated CCC or worse, and they’re in the first quartile as it relates to the actual number of defaults over time. So we think — obviously, it’s a stressed environment or has been a stressed environment for senior loans, but on a relative basis, our portfolio is holding up.
Our next question comes from the line of Geoff Kwan from RBC Capital Markets.
First question was just — the OP IV IRR has been ticking up nicely. Just wondering if there’s any comments you have on how that’s stacking up versus peers. I can appreciate you may not have any sort of numbers around Q3 yet, but just how that other — the quartile, percentile trend has been in recent quarters.
Bobby Le Blanc
Yes, Geoff. I think it’s important that we get those numbers because some of the PE firms that we’re competing against, obviously, may have more consumer-facing exposure than we do. But really, what I’m most focused on, making sure we get to earn the carry in that fund. And we’re getting really close to that, as Chris and I both mentioned in our remarks.
Okay. And then my second question was just on Slide 18, where you show the returns for your different COVID buckets. On a quarter-over-quarter basis, I mean, the low/positive impact was up 18%. It was 11% up for direct exposure and then 9% for those that had — in the demand/supply headwinds. Now when I kind of look at that — those data points, I kind of think the low/positive bucket includes some businesses that evidently would have done well in Q3 given the recovery.
But I’m just wondering, is the way to think about why the gains were lower for the companies most impacted by COVID is because, even though there were reopenings and the economic growth was improving, the businesses that you would have in that bucket are ones that would not necessarily have participated in the early stages of this recovery?
Bobby Le Blanc
I think that’s exactly right. Like so if you think about an ASM or an Emerald, right, even though the economy is picking up, their actual businesses haven’t. Or in the case of a Parkdean, once the parks open, they began generating very good revenue and profits, and they would be a contributor to our positive growth this quarter. But by and large, the businesses that are directly impacted, they haven’t really gotten the benefit of the recovery yet.
Okay. Great. And just my last question, just going back to the CLO expected lower returns. I suspect that doesn’t change your appetite in terms of doing new CLOs, but does that impact your appetite in terms of how much you plan to invest in the equity tranches of the CLOs? Because I think with the regulatory changes, I think it was last year, you don’t have that requirement that you would have had from two to three years ago.
Bobby Le Blanc
Yes. So our most recent CLO, CLO-20 in the U.S., we actually syndicated 2/3 of the equity upfront. So in terms of the return on invested capital there, if you take into account the fee income, that ought to be really attractive. And that doesn’t mean we’re going to syndicate the equity every time, but right now, just looking at the market and the pricing in the market, we thought that made sense. I do think, overall, the CLO business will become less capital-intensive over time, and we’ll do a better job taking advantage of syndicating that equity and creating a better ROE for that business.
[Operator instructions] Our next question comes from the line of Scott Chan from Canaccord Genuity.
Bobby, you talked about OP IV and the performance, and outside the public marks that we see, you kind of called out Parkdean and PowerSchool. But I’m just wondering kind of post quarter, now with the second wave, perhaps an outlook on those two businesses right now.
Bobby Le Blanc
So Parkdean essentially shuts down their parks this time of year, so I don’t anticipate a second wave here having any meaningful impact there. What we normally do in that business in the off-season is CapEx projects, maintenance projects and things like that, which I think we’ll still be able to do. So very little impact there. And the same with PowerSchool.
I don’t anticipate a second wave to hurt PowerSchool. As a matter of fact, in terms of its in-school education tools, it might actually be better because that’s what we saw in the first wave of COVID. And just generally speaking, I think we’re more prepared for a second wave overall in our businesses than we would have been in March. We have the protocols and plans in place. Hopefully, it doesn’t — the wave isn’t that big this time. But if it is, I think we’ll be more prepared this time around than last time around. But those two businesses in particular, I don’t see getting — having a negative impact.
And just maybe moving over to Gluskin Sheff. When you acquired the firm, the annual net income at the time was substantially higher than what you did this quarter. You kind of talked about lower fees to make it more competitive, assets have been down. But how do you generate better earnings from that wealth management part of the business?
Bobby Le Blanc
I think the way you earn better — the way you improve your earnings, you got to grow AUM, right? And the way we grow AUM is by having great product offerings and pivoting to the wealth management strategy. All of our efforts right now are trying to build that business into not only an asset manager, but a world-class wealth management firm in the Canadian market. That’s going to take some time, that’s going to take some investment in technology, but that is the plan. And I think the Canadian market is ripe for an offering like that, for an independent wealth management firm. So I have some — I think we’ll get that on track, and we’ll get the AUM growing.
And maybe just lastly on that, Bobby. The cross-selling has been pretty good, as stated from the start. I think you noted $570 million to date. But if I look at the flows this quarter, there are net outflows of almost $300 million. That’s almost like a double-digit annualized rate. Did something in particular happen this quarter with clientele? Or just kind of getting a read-through on kind of the visibility on future flow traction.
Bobby Le Blanc
No, there was nothing unusual this quarter. And a lot of the dollars that we did lose were not high fee-paying dollars. They’re relatively low fee-paying dollars. But there’s nothing I can point to as a cause for that reaction, nothing unusual.
And this does conclude the question-and-answer session of today’s program. I’d like to hand the program back to Bobby Le Blanc for any further remarks.
Bobby Le Blanc
Thank you very much for participating today. Obviously, if you have any questions, feel free to follow up with Jill. And I hope you all have a nice weekend. Thank you.
Thank you, ladies and gentlemen, for your participation in today’s conference. This does conclude the program. You may now disconnect.