[REPLAY] Private Equity Masters 6 – Doug Ostrover – Blue Owl Capital (Capital Allocators, EP.205)

0:04Hello, I'm Ted Seides and this is Capital Allocators. This show is an open exploration of the people and process behind capital allocation. Through conversations with leaders in the money game, we learn how these holders of the keys to the kingdom allocate their time and their capital. You can keep up to date by visiting CapitalAllocators.com. Over the last decade or two, no asset class has generated as much interest and investment dollar returns as private equity. This eight-part miniseries, Private Equity Masters, is a set of conversations with some of the longtime leaders in the space. We'll hear their stories, those of their firms, and their perspectives on this all-important area of the capital markets.

0:59My guest on the sixth episode of Private Equity Masters is Doug Ostrover, the co-founder and CEO of Blue Owl Capital, a public company born out of a merger between Alrock Capital and Dial Capital. Doug is also the CEO and co-CIO of Alrock Capital, a direct lender to middle market companies that he co-founded in 2016 and today manages $30 billion in permanent capital assets. The combined Blue Owl manages approximately $53 billion in assets, over 90 % of which is in permanent capital vehicles. Previously, Doug was one of the founders and the O in GSO Capital Partners, which today is Blackstone's alternative credit platform.

1:45He's been involved in leveraged finance, working with private equity sponsors for 30 years. Our conversation covers Doug's beginnings in leveraged finance, the founding of GSO, and keys to his early success. We then turn to the importance of culture, sourcing investment opportunities, the underwriting process, and working with both GPs and LPs. We close with Doug's perspective on the recent formation of Blue Owl and what the future holds for direct lending. Please enjoy my conversation with Doug Ostrover. Doug, great to see you. Well, thanks for taking the time today. I appreciate it. Why don't we go back to the beginning and maybe start with what drove your initial interest, even in just the business world?

2:32I grew up in Somerset, New Jersey, middle-class area. It was a Levittown with four different styles of homes. And the rich people in our neighborhood, they had one extra tree because everyone's landscaping was identical. My father was in the textile business. He worked for his brother. We were very close. And I was always enamored of business and sat at his hip and learned a lot. But I have to admit, with regard to Wall Street, I had no exposure. I mean, in that area where we lived, there was no one who worked on Wall Street. And so it really wasn't until I got to college that I got any real exposure to Wall Street.

3:19and I was fortunate enough to get a job after lots of rejection, but it's somehow all worked out. So if you go back in those early Wall Street years, early on, you got into leverage finance, what was it that made it an attractive place to be? Well, if I'm being 100 % honest, I didn't pick leverage finance. Leverage finance actually picked me. And I pinched myself every day that I was fortunate enough to get into it. I started my career at a firm called EF Hutton, which probably most of your listeners have never heard of, but it was a pretty big firm back then. And I was in a program where I rotated around the firm.

4:02And I probably didn't make the wisest choice, but I decided that I would go into municipal finance. And at the time, this was probably 1985, maybe 86, that was one of the most profitable areas at EF Hutton. And the group I was fortunate enough to get a job with specialized in a form of public finance called industrial revenue bonds, which is a fancy way of saying they would go to companies, they would help them do a financing on a project that would help a community. And if it was helping a community, they could get municipal status, which means interest rates were very high then, but municipal rates were much lower, so they could save a lot.

4:48So we're working with small companies, building a small factory. It would be 10 employees. We'd get it qualified for this municipal status, and we could save hundreds and hundreds of basis points. So one day I wake up, I'm walking to the subway, I get my Wall Street Journal, and they've changed the tax code. And they have outlawed this area that I had focused on. And so I take the subway downtown. I think I'm 26 years old at the time, and I'm certain I am out of a job. And I've only been working for three, four years. And so I show up, and they said, pack up your things. And I thought, again, we were getting fired.

5:30And they said, you know, this team has worked with a lot of small companies. We're going to move you across the street. You're now the new junk bond group in corporate finance. And that's how I got involved. Pure luck. Drexel was the dominant firm at the time. And we were setting off on a course to try to get maybe a point or two of market share. So it was an exciting time. I think it was 86, 87. And I was very fortunate to get involved in it. What do you remember most of your earliest lessons in the business? I have to admit, having been in public finance, moving to corporate finance, I was still prepared.

6:07And it was much more accounting focused than working for a municipality. And I remember sneaking out and getting tutored by a professor at NYU on financial modeling and just getting better at accounting. So it was a year or two of really hustling, but it was an interesting time because Drexel was still the dominant player in the marketplace. So to pick up any market share was a real challenge, but this was a really small group. So as a 26-year-old associate, I had the flexibility to call on companies and pitch them. And I was very fortunate. It was exciting. So how did it evolve from there through the rest of your time on the south side of the street?

6:56So EF Hutton had some financial issues. I left Hutton and I went to a firm called LF Rothschild, and then they had some issues. At Rothschild, I had made the move after a couple of years of banking. First, I became what was called a desk analyst working on special situations. and then I moved into sales. Rothschild had some issues, so I went to Wasserstein Perella, who had started a high-yield business. I liked being chosen to go into leverage finance. I decided I wanted to go to a bigger firm, and I got offers from two firms. One was Bear Stearns, and the other was a firm called DLJ, Donaldson, Lufkin, and Jen Red.

7:41They're both great firms, but I really liked the people at DLJ more. There was just something I related to. The problem was DLJ was offering me materially less than what Bear was offering me. But I just decided I'm going to take a long-term approach and I'm going to take the offer at DLJ. So I go to Bear Stearns. I tell them, look, unfortunately, I'm going to go across the street to DLJ. This is a true story. So I'm living in a two-story walk-up, only air conditioning in the bedroom, not in the living room, just to give you an idea what it was like, but a great apartment. And so I come home. If you remember the old-fashioned answering machines, you'd have to go and hit the button.

8:30So I hit the button, you know, it makes the sound beep. And I hear the guy with a bit of a Southern accent. He says, Doug, this is Ace Greenberg on the phone. I hear you're about to take a job at DLJ. Before you do that, any chance we could have breakfast tomorrow? So I think I'm 29 at the time, maybe just turning 30. And Ace Greenberg was a legend. He ran Bear Stearns forever. I had never met him. And I have to tell you, I thought someone was playing a joke on me. I thought one of my friends was playing a joke. So I had my wife call the number he left. And someone answered, said Greenberg Residence.

9:11So we hung up immediately. A few hours later, I called. And I went over and had breakfast with him the next day. And just an incredible gentleman, so impressive, insightful. and I really enjoyed my time with him. Unfortunately, he ran the firm and I wasn't going to be working for him. And I decided to go to DLJ and I would say is probably one of the best decisions I've ever made. There's that movie with Gwyneth Paltrow. I think it's called Sliding Doors. She runs to get the subway. One part of the movie is she makes it and she ends up meeting her future husband. The other one, she misses it, stays with her current boyfriend.

9:55Both work out fine. Both would have worked out fine. But DLJ was a special firm and I made some unique partnerships there. What led to you ultimately leaving and co-founding GSO? I started at DLJ in 92. I left in 2005. Now in 2000, DLJ was bought by Credit Suisse. In 2005, there was a change at Credit Suisse. John Mack, who had been the CEO, was pushed out. And a guy named Ozzy Grubel, who was his co-head, took over. And then they anointed a guy named Brady Dugan, who we were friends with, to run the US. But we thought that was a good time to pass the reins. And we had been really intrigued with the asset management business.

10:44And so with my two partners who we had been running the business. Actually, Bennett Goodman ran the business. We worked for him. But the three of us said, Bennett Goodman, Trip Smith, and myself, let's go start this firm called GSO. We're going to do something that nobody really had ever done. And that was marry both public market expertise with origination. And direct lending wasn't really a thing back then. And we thought we had originated tens of billions of product over our career. And we thought we could continue to do that and not be so reliant on Wall Street. So we left. And as you can imagine, leaving a really nice high paying job, it was nerve wracking.

11:29And remember, we left in 05, 05, 06, 07 were some of the best years ever for Wall Street. So people were calling us constantly saying, you guys made the biggest mistake of your lives. Why would you leave? We're killing it. But we had a great partnership and we built a really good business there. Over the course of the period of time, both at CSDLJ and then GSO, what are the key components that allowed you to be successful both on the sell side and leverage finance and then lending to companies directly. The one thing I learned at a very early part of my career is how important it is to have great partners.

12:13If you can find people who you think are better than you in a lot of parts of business, but together, you know, if like we had three of us, if we could take one plus one plus one and make it equal four or five, that's pretty valuable. And so I've believed in that since day one. The other thing is it's a people business and you've got to hire great people. And I think as an owner of a business, you have to be willing to share the economics. You have to be willing to get the best people. You have to create a great culture. And this is a people business. So we set out both at GSO and at my current firm to really attract the best and the brightest and give a great work environment as well as chance for upward mobility and to be really well compensated.

13:04So I want to fast forward. When you started Alrock, what does that culture mean to you and what culture did you seek to replicate? When I left Blackstone in the summer of 2015, I started thinking about leaving in 14. and it wasn't like I was unhappy there. It's an amazing firm and I felt really fortunate that we sold our firm to Blackstone because we sold in 08. So we were able to get through the crisis being part of Blackstone and I learned a lot there. I learned a lot about culture, watching people like Steve Schwarzman and John Gray, especially watching them during a crisis. They led by example and they were calm and cool and trying to figure out, you know, there's a lot of pain in the world, but how could we come out of this stronger?

13:53And they came out much stronger and that helped our business. But as I think about the culture we were trying to create, I think we saw an opportunity to create a culture that we could give people, our investors, the same experience, the investment experience as a Blackstone, a KKR, a Carlisle, Apollo, any of the big firms. So whether it's anything in our back office, compliance, legal, cybersecurity, make that as good as you would find anywhere in the world. Build an investment team. I think it's better, but as good as anyone. My real goal, though, was to create something that was a little kinder, a little more gentle, no FaceTime.

14:39People don't believe me, but I spend a lot of time talking about this and I really believe it. I think you can have a work-life balance. And so I tell everyone, don't miss your kids' school plays. Don't miss the parent-teacher event. Don't miss your spouse's anniversary. Don't plan that business trip to Asia when all of this is going on. Culture is an intangible. You know when it's working, you know when it's not. We have some very basic tenets. When you're here, you have to treat everyone with respect. We expect excellence, but you treat everyone with respect. The other thing is we want to hear everybody's voice.

15:20You think we're doing something we could be doing better. We want to hear it. If we're making an investment, we don't care if you're just out of college. If you think it's a bad investment, don't walk out of the room and whisper to your friend, oh, that's a terrible deal. We want you to speak up and no one's going to be critical. And so the culture is really working. And we have today about 300 people, and we have not had one person in six years voluntarily leave, not one. And we're continuing to grow and build, and it's an exciting place to be. But we spend a lot of time talking about culture, doing offsites on culture, and looking for input from everyone on how to make it better.

16:04How do you balance the kinder, gentler desire of the firm in such a competitive landscape outside the firm? When I talk about things like mutual respect and constructive discussion, those are easy. Now, on the other hand, we are talking about, we expect excellence from people. I'm a big college football fan. I can't remember which coach. I think it was Nick Saban. but he said, listen, when you come to practice, we expect 100 % effort, 100 % of the time. That's what we expect when you're here. But we think if you're doing that, we can give you balance. And I think that's what we've largely achieved.

16:47Now, look, we're only a six-year-old firm. We're growing a lot. Time will tell if we can maintain it, but I'm pretty convinced that there's more than one way to run a business. And you can run a firm and I think be highly successful. And people don't need to be here every night till three o 'clock in the morning, just to say that they were here till three in the morning. So I want to turn to the firm and the investment side of the business. So why don't we start with when you created OutRock, what were you trying to accomplish as your own strategy? We started the firm in 2016, and I was lucky to be at Blackstown when I left.

17:29I think we had 80 billion, 90 billion. I don't know the exact number, but it gave me the ability to see quite a bit. I started becoming convinced that direct lending, which is what we specialize in, was going to become a really big asset class. Back in 14 and 15, most big institutions, they allocated to it, but in relatively small size, and it wasn't a separate asset class. And as I went out and started talking to folks, I realized that they were going to allocate a lot more money. And at the same time, more and more private equity firms were becoming intrigued with not going to one of the big banks, but going direct to somebody like us who could provide a bespoke solution.

18:13When I looked at the world, it's pretty interesting, the competitive landscape. If you were to draw a pyramid and you go to the bottom of the pyramid, the widest part, there were a lot of firms that could make loans of 10 to$20 million. Then you work your way up to 40 to 60, and then 60 to 80, and 80 to 100. When you got to the top of the pyramid, the number of firms that could actually make loans of two, three, four, 500 million and hold it was relatively small. And so I noticed that and I was surprised because that's where I like to invest. Because think about it, if I'm lending to bigger companies, most likely I can better protect the downside.

19:00They have more levers to pull to avoid bankruptcy. And what we have always tried to do is lend to a company that's number one, two, three, four, maybe five in their sector. So let's say a company does get in trouble. they're number three in the marketplace. You know companies one, two, four, five are going to have to look hard at that asset. And so the basic premise that we've created and we've really executed on this is protecting our investors' capital. Remember, we are a fixed income security. We're making senior secured floating rate loans. And our job is to earn a premium versus what they again in the syndicated high yield market or the syndicated loan market.

19:46The other thing we need to do is because we can do a lot more diligence than a syndicated participant is to make sure we better protect the downside. Whatever the loan losses are in the syndicated market, we need to do a much, much better job because we have better information and we've been able to do that. So I was excited when I saw less competition at the top of that pyramid and I could finance bigger companies. And that's where we focused. So how do you go from a ground start to amounting sufficient assets that you can make loans in that size and still have a diversified portfolio? Yeah, it's a really good question because going out with that, it'd be much easier to say, we're going to do 10 or$20 million loans.

20:27You raise a half a billion dollars, you're in business. We had to go raise billions. I think we were fortunate. We put together a great team. I brought in Mark Lipschultz, who was at KKR, Craig Packer, who was at Goldman, Alan Kirschenbaum, who was at TPG. And the whole idea was, let's give everyone, our investors, that big firm experience, but as a new boutique, but highly focused, focused on one thing, and let's be best in class at it. And it resonated, and there's an element of luck to this. And trust me, when I was sitting in my lawyer's office, we were working out of a conference room, interior conference room, no windows.

21:08There were like 12 of us. That's where we went every day for months. In fact, before I got the conference room, I used to spend every day at the Putnam Diner in Greenwich in the back booth. I was the number one customer. That was my office to save rent. When you're starting something new, it's really scary, but we were fortunate. We got a great response in the market. We raised$6 billion. We use a turn of leverage. So we had $12 billion of firepower when we launched. We had our first close at the end of the first quarter in 2016, and we really haven't looked back since then. But you can imagine when you're starting and you're trying to attract people and you don't have an office, I don't even know if we had a name.

21:52We didn't have any capital. Now, I had come from GSO and Blackstone, and we'd had a lot of success there. But to get people to leave, Goldman and Morgan Stanley and other direct lenders, I had to take a lot of risk and believe. And I'm incredibly grateful to all those people who took that leap with us. Obviously today, now we're blue out, it's much easier to attract great talent. But when you're just launching, that's away from raising the money. That's probably the hardest thing to do because you're trying to get someone who's at a point in their career where they're senior enough and you're asking them to take a lot of risk.

22:28Now, you're hopefully offering them a good reward if it all works, but it's not for the faint of heart, that's for sure. So when you turn to this investment strategy predicated on protecting the downside, how do you go about filtering your investable universe to figure out where you want to make your bets on loans? The one thing I would say I was maniacally focused on is what's called our deal funnel. I thought the mistake a lot of direct lenders make is they don't put enough resources into their business, people, to create a very large deal funnel. So for example, if you only have four deals in-house and your best deal maybe checks six of the 10 boxes you want to track, you do that loan.

23:14So what I wanted to do was make sure we had a deal funnel that was as big as any of our competitors, but probably have a little less capital at the bottom of that funnel. So more deals per dollar of investable capital than any of our peers. That's what we set out to build. I can't prove it, but I can tell you I feel pretty confident that we've achieved that. We cover today over 700 private equity firms. We've worked with well over 500. We've done over$30 billion of financings. I don't know the exact number, but probably 200 line items. I think the other thing we've done that most people aren't aware of is early on, today, retail, high net worth is really in vogue.

24:06So a lot of firms, KKR, Blackstone, a lot of firms are active in that. But when we launched the firm, we decided we were going to be very active in that space. So we started that strategy six years ago. And what we did, which is different, and I don't know how they're running it today, but I looked at a lot of firms with REITs. And I noticed most of the REITs were sold to retail. And then there was institutional capital. And the institutional capital and the REIT capital were playing in different investments. What we decided was we were going to create a retail sleeve that would play in the identical investments as our biggest investors.

24:49So let's really bring to the retail market a true institutional quality product. And I'm not saying the others aren't, but we just decided to do ours a little different. And so we find a loan, there's no cherry picking. We find a loan, it gets allocated to our institutional fund and our retail fund based on their assets. So the portfolio is not 100 % identical because of timing when they both started, but pretty close. When the investment team goes and narrows that filter, are there either certain sectors or characteristics of companies that tend to make it through relative to others? Yeah. I mean, we decided early on since preservation of principle was the key to us, First, we start with industries.

25:35And so we decided we're not going to play in retail. We're going to avoid oil and gas. We're really going to avoid things that are going through major secular change. So you can imagine when we launched with$6 billion, we're just getting going, every newspaper chain in America came through our office. It was a fresh pool of capital and they need capital. Now, some of those newspaper chains are going to be fine. But the question, which we couldn't answer, if I made a five-year loan, what is the value of that newspaper chain in five years if it defaults? We don't know. And so we've decided to focus on things that are more annuity-like.

26:15So we're big in insurance. Our single biggest sector is software. Software, I think today we are probably, I don't know if we're the largest, but we are one of the largest dedicated lenders to the software space. We have 22 people focused on software, half in New York, half out in Menlo Park. So, I mean, clearly Silicon Valley Bank is the single biggest player, but we're definitely, I think, top two or three. And if you think about software, I think this will summarize what we look for. If you can find a piece of software that's mission critical, and so it's really involved in helping a company run, and there's very little churn, and we can look at cohorts over a long period of time that once it's installed, it doesn't churn off.

27:06What that means is you have a credit where the revenue base is very stable. Now, a private equity firm is buying it because they think they can really grow that revenue base. But we're looking at it and saying, if that revenue base does nothing but stays really stable, will we get our money back? And the way we do that is by loan to value. We make sure that we're coming in at a reasonable loan to value. And I don't know where we are in software today. I think around 10 billion of loans. Every single software loan that we've made is hitting or exceeding its underwriting case. And that's coming through the pandemic.

27:44Obviously, we have some stuff that might touch hospitality or aerospace, but our core sectors have really come through relatively unscathed. And so healthcare is another one. So we're looking at things like that, that are more stable and the cash flows are a little more annuity-like. But having worked with, call it, 500 sponsors. How do you think about the part of the underwriting that involves who that ultimate owner of the business is? The good news is we have a bunch of people at the firm who have really senior relationships at most of the firms we work with. And we've seen their behavior over a long period of time.

28:30We are not interested in taking over anyone's company. So we're a really good partner because you hit something like the pandemic. And if let's say you needed a covenant waiver, if you had a public bond outstanding, you had to go negotiate with a hundred different parties, maybe 200. During the pandemic, if we were the lead on one of your deals, you just had to negotiate with us. So what we asked of a PE firm was shore up your balance sheet. Let's make sure you have liquidity if this crisis goes on longer than expected. And if you do that, we'll waive your covenant. Maybe we want a little more rate.

29:08Maybe we need a fee, but we'll make it reasonable and we'll give you the ability to extend that equity option. And so we have the luxury of cherry picking because we cover a lot. And by the way, we cover 700 PE firms. We also call on a lot of large private companies. We're looking for people who want to make it a win-win. We're not looking for somebody where when it gets tough, they're calling and saying, paragraph C, line item two, we believe there's the ability for us to put more debt or to strip out assets. There's a lot of ways to parse through an indenture. I used to run a distress fund, and I've looked at all of them.