Undervalued Asset Manager Shoots for the Stars
Apollo looks to be one of the best-positioned alternative asset managers in credit.
Apollo Global Management's (APO) specialization in illiquid credit instruments offers substantial potential in the coming years. Banks of all sizes, under tough regulatory scrutiny following the Great Recession, are shedding risky and complex credit assets to shore up their capital ratios. We see this trend as a secular one, particularly as Basel III rules continue to force banks to shed risk, and Apollo's relationships and deep expertise in the market position the alternative asset manager to earn lucrative returns.
The acquisition of fixed-annuity provider Athene in late 2013 differentiates Apollo from its peers, in our view. Apollo's permanent capital base with Athene is just over $60 billion in assets under management, almost 40% of Apollo's overall AUM. Unlike private equity funds, which have a lifecycle of 7-10 years, Athene's assets under management do not need to be returned to investors, meaning that Apollo can earn steadily greater fees from Athene as it invests more of Athene's AUM into Apollo funds. Furthermore, there is substantial opportunity to reposition Athene's AUM toward exactly the type of illiquid credit investments that Apollo has been buying up in its own funds, boosting Athene's returns and, more important, generating capital to be used for further acquisitions of insurance float (and thus Apollo's AUM). Finally, as Athene is a fixed-annuity provider, its costs are generally fixed, while Apollo's investments for Athene are generally in variable-interest securities, meaning it should benefit from higher interest rates through a wider spread.
While we see Apollo's largest opportunity in credit in the coming years, its highly respected private equity business should still do well. In 2013, Apollo raised the industry's largest fund ever, Fund VIII, with $17.5 billion from outside investors in just 10 months. We see much of this capital being deployed in North American oil and gas. Developing North American tight oil and gas reservoirs is extremely capital-intensive, and oil and gas companies are selling older and more conventional assets with shorter reserves lives that are not quite as low cost as tight oil and gas plays, giving Apollo a large opportunity to put capital to work at strong returns.
Reputation and Sticky Assets Provide an Advantage
We give Apollo a narrow Morningstar Economic Moat Rating. Traditional asset managers typically benefit from intangible assets and switching costs as moat sources in the form of substantial reputation benefits as well as sticky assets. We think alternative asset managers like Apollo benefit even more than the traditional asset managers from these sources, given the less transparent nature of the lucrative returns they earn; the vast majority of Apollo's investments are typically in nonpublic assets. Today, about 70% of Apollo's fund investments are valued based on exchange or broker quotes, but we see this as a temporary condition as a result of Apollo's aggressively harvesting its private equity portfolio over the past two to three years. As Apollo invests its Fund VIII monies, it will rely more on non-market-based valuation methods. In any case, these assets tend to be sticker than traditional assets, as private equity funds typically have 7- to 10-year lockup periods, meaning investors see a return of capital only when an investment is realized, which is at Apollo's discretion.
While absolute investor costs for switching asset managers are generally small, investors tend to stay with managers because of inertia. Performance certainly helps, and Apollo's internal rates of return across its major private equity funds are around 26% over 20 years. Institutional investors (nearly 80% of industry AUM) also prefer to invest in established managers, and an estimated 90% of industry asset flows go to funds with assets of more than $5 billion. Finally, with Athene's AUM making up 40% of Apollo's AUM, the company has a large source of permanent AUM (Apollo's contract to manage Athene's AUM can technically be terminated, but as Apollo has substantial influence over the AP Alternative Assets entity that owns Athene, we see this as extremely unlikely) from which it can extract fees consistently over time.
Illiquidity Central to Strategy, but Brings Risk
Apollo's private equity and real estate investments are highly illiquid. Indeed, this illiquidity and associated complexity is a core part of Apollo's investment approach. Tightened credit conditions could limit the firm's ability to move into new investments (though Apollo has invested 40% of its funds in a down market), while weak economic conditions and difficult equity and credit markets could affect not only the value of its investments, but also its ability to cash out. The firm's investments in real estate also subject it to the risks inherent in the ownership and operation of real estate and related businesses and assets.
With incentive and transaction fees accounting for a significant portion of annual revenue, the volatility inherent in these types of fees can have a major impact on the firm. Our fair value estimate anticipates steady fees across Apollo's funds, so our fair value estimate may be too high if fees fall. More important, poor investment performance not only affects revenue, profitability, and cash flows, but also could obligate the firm to repay carried interest earned in prior periods and potentially have a negative impact on the company's ability to raise new capital for future investment funds. Any financial stress experienced by the firm would be compounded by the fact that Apollo has taken on a fair amount of debt via a credit facility during the past few years.
Regulators Continue to Pressure Private Equity With Proposed Leverage Cap
The Federal Reserve and the Office of the Comptroller of the Currency issued guidance last year that asked banks to avoid financing leveraged buyouts where debt on the company would be more than 6 times EBITDA. Longer repayment timelines and covenant-lite loans should also be limited to reduce risk. These rules have the potential to make it harder for private equity firms like Apollo to complete deals, reducing their returns. To date, banks and private equity firms have indicated that the guidance is unclear, particularly if a deal meets some but not all of the criteria outlined as risky. We believe the banks will have a clearer picture of how this guidance will be enforced once regulators have completed their annual review of the industry's loan portfolios, which should be completed in the next few months. Meanwhile, The Wall Street Journal has noted that about 40% of leveraged buyouts completed this year exceed the 6 times EBITDA debt cap.
At this time, we don't think any proposed leverage caps will have a significant impact on the private equity industry for a few reasons. First, we think it will be very hard for regulators to enforce any guidance or rules, because guidance is typically subject to interpretation, and rules cannot describe the exact actions to take in every single scenario, so banks will continue to have substantial leeway to make loans as they see fit. Second, if banks decide to pull back on private equity deal financing, the private equity firms can turn to nonbank lenders that are not regulated to obtain the financing they require. In fact, several private equity firms (including Apollo) serve as external managers for publicly traded business development companies, which specialize in exactly this type of middle-market direct lending.
Stephen Ellis does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.