High Hopes for Apollo's Athene Acquisition
Positioned to benefit from the shift to nontraditional lenders, narrow-moat Apollo now needs to ensure the success of the Athene merger.
Over the past two decades, Apollo Global Management (APO) has grown into one of the asset management industry's most powerful private equity players and its strongest credit-focused firm. Its 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 as a secular trend, particularly as Basel III rules force banks to shed risk, and Apollo's relationships and deep expertise in the market position the firm 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 life cycle of seven to 10 years, Athene's AUM does 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 in Apollo funds. Furthermore, there is substantial opportunity to reposition Athene AUM toward 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 AUM). Finally, as Athene is a fixed-annuity provider, its costs are generally fixed, whereas Apollo's investments for Athene are generally in variable-interest securities, meaning it should benefit from higher interest rates through a wider spread.
Though 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 reserve 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.
Our Fair Value Estimate Is $40 per Unit
Our fair value estimate is $40 per unit, which implies a 2015 price/economic net income multiple (the industry's preferred metric) of 13 times and a dividend yield of 6.0%. On a distributable earnings basis, which is our preferred metric because it removes the effects of unrealized incentive income and is closer to cash earnings, we value Apollo at 14 times our 2015 forecast. We're fans of the attractive nature of the alternative asset manager business model versus traditional asset managers. The alternative asset manager model includes higher profitability and secular tailwinds (increasing allocations from institutions), and we could see multiple expansions over time as investors obtain greater levels of comfort with the lumpier, but recurring, nature of performance fees over long time horizons. That said, we expect that the industry's use of the partnership rather than the traditional corporate structure means that the alternative asset managers will still trade at a discount to their traditional peers, probably because of potential tax ramifications, thanks to the industry's use of K-1s, which create tax complexity, and the carried interest tax issue. We also assume that carried interest tax reform eventually passes in some fashion, and our long-term tax rate is 35%, but we do not see any near-term threats to the industry at this stage.
We expect results to weaken from 2013 levels, as Apollo will find it impossible, in our view, to replicate the success both of 2013's LyondellBasell profits and the close of its Fund VIII. Accordingly, we expect fee-earning AUM levels around $133 billion in 2014, economic net income of about $1.1 billion (distributable income is similar), and earnings per unit of $2.66. Beyond 2014, we expect modest earnings and AUM growth driven mainly by healthy markets, Apollo's strong reputation, and continued solid fund performance. That said, if Apollo and Athene continued to make aggressive acquisitions of credit-related AUM, our forecasts could prove conservative. In 2017, we project total AUM at $201 billion, economic net income of $2.0 billion, distributable earnings of $1.8 billion, and economic net income per unit of about $4.92.
Stickier Assets Bolster Apollo's Narrow Moat
We believe Apollo has earned a narrow moat. 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 traditional asset managers from these sources, given the less transparent nature of the lucrative returns they earn, as 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 stickier than traditional assets, as private equity funds typically have seven- 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 tend to be 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 over $1 billion. Finally, with Athene's AUM making up 40% of overall AUM, Apollo 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.
Apollo Faces Continued Pressures From Regulators and Limited Partners
We consider Apollo the best-positioned alternative asset manager to benefit from the secular shift in transferring riskier assets from banks to nontraditional lenders because of its deep expertise in valuing complex and illiquid credit securities. Apollo’s credit AUM base at more than $100 billion is substantially greater than its next closest peer, Oaktree, at $80 billion, which we believe provides a deeper base of relationship with investors (both buyers and sellers), investment expertise, and global infrastructure to better pursue new credit investments. Furthermore, like Warren Buffett at Berkshire Hathaway, we see an opportunity for Apollo to expand its base of permanent capital via further acquisitions or share gains through Athene's fixed-annuity operations. The capital provides a stable base of AUM that will not demand redemptions at inopportune times or seek liquidity after a certain time frame has passed, and we believe it conveys a substantial advantage to Apollo over its peers.
We think Blackstone (BX) is one of the few peers capable of duplicating Apollo's move with Athene, as smaller peers do not have the capital or relationships in place to do so. Apollo's relationship to Athene is through its Apollo Alternative Assets entity, a closed-end limited partnership, which was formed in 2006 and funded with $1.9 billion in capital to invest alongside Apollo in private equity investments, among other opportunities. The advantage of the vehicle is that Apollo has a ready source of capital to pursue investment opportunities rather than engage in a lengthy fund-raising period. In late 2012, it exchanged all of its investments for a majority ownership in Athene. Blackstone needs to pursue a similar path, in our view, if it wants to duplicate Apollo's strategy. That said, asset prices are probably 50%-75% higher than when AP Alternative Assets purchased Athene, Blackstone must buy its insurance arm through an appropriate subsidiary and accept the fact it will be overseen by insurance regulators, and finding the right asset might be very tough. Athene was fairly unusual in that it was started in 2009 by a savvy management team and designed to pursue distressed credit opportunities through an insurance operation, versus similar-size peers, which are usually arms of traditional insurance companies. It's notable that it took Athene five years to build up a suitable base of AUM, and this was through acquiring fixed-interest-rate annuity operations in a period of low interest rates when the operations were most unloved; we consider this another modest barrier to entry.
That said, we continue to see pressures from regulators as well as limited partners. The Securities and Exchange Commission has created a new unit to focus on private equity and hedge funds. The unit is headed by Igor Rozenblit and Marc Wyatt, who both have backgrounds in private equity and hedge funds. The SEC's review of the industry began shortly after the 2010 Dodd-Frank Act, which placed the industry under the agency's purview for the first time. According to an internal SEC examination of about 400 private equity funds, more than half of the funds have charged investors unjustified fees without notifying them. When limited partners commit money to a private equity fund, the partnership agreement typically spells out the fees that the investors pay, which are typically management and incentive fees, but also the fees that portfolio companies pay the private equity firm, which can be transaction, monitoring, and many other types of fees. Depending on the agreement, the private equity firm can command a greater proportion of these additional fees versus the standard 80/20 split, which feeds into the firm's management fee income. After investor pressure in recent years, these fees are generally rebated to limited partners. The SEC appears to be focusing on fees that are not mentioned in the original partnership agreement, which allows the private equity firm to keep the entire fee for itself, as well as general misuse of the funds.
Regulators are also seeking to restrain some of the industry’s more aggressive actions with their investments. In Europe, regulators have approved a directive for alternative investment fund managers that includes guidelines regarding asset stripping and dividend recapitalizations for 24 months following an acquisition, as well as increased levels of transparency, including requiring the manager to set a maximum leverage limit, taking into account the given fund's strategy, sources of leverage, and collateral. Denmark and Germany have adopted legislation that limits the deductibility of interest expense, a key source of tax savings and returns for the private equity industry. Similar guidelines are being looked at in the United States, where regulators have suggested that banks providing loans for acquisitions where debt is greater than 6 times EBITDA be subject to substantial additional scrutiny.
Pressure on the private equity industry is also coming from limited partners. In 2009, limited partners concerned about the alignments of interest between limited and general partners started the Institutional Limited Partners Association, which now represents more than 250 limited partners that invest over $1 trillion in capital. The group's latest set of recommendations (issued in 2011) lays out key principles that general partners such as Blackstone and the rest of the industry's major players have agreed to honor. Key areas of focus include lowering management fees following the investment period, asking general partners to contribute cash to fund at least 3.5% of a fund rather than waive management fees, better disclosure of all fees (transaction, monitoring, advisory, and so on), more timely liquidation of "zombie funds" where the investments are not panning out but the general partner is still collecting management fees, and the use of the more conservative European waterfall approach versus the deal-by-deal approach for carried interest, which means the limited partners may have to engage in legal action to obtain any clawbacks if the fund fails to perform well in the latter years of its useful life.
Outcome of Athene Acquisition Yet to Be Seen
Key to the firm's success have been co-founders Leon Black, Josh Harris, and Marc Rowan, who still own the majority of the firm and have complete voting control versus external shareholders. While this level of control means shareholders will have a limited voice in any firm decisions, it's hard to argue that the group hasn't created significant shareholder value, as well as wealth for themselves. For example, we do consider the dividend payouts rather shareholder-friendly. That said, we rate Apollo's stewardship as standard versus exemplary because we've yet to see how successful the Athene acquisition will be in terms of fee-generating power for Apollo, as well as how the Athene capital can be deployed toward future acquisitions, which are both elements that will determine how successful this previously untried strategy in alternative asset managers will be. We have high hopes for the merger, but given the significant range of outcomes at this stage, we don't think exemplary is warranted yet.
We'd also note that unlike peers where succession plans are less clear, Apollo investors have a very clear line of sight into the next level of its leaders after Black eventually retires, in our view. Black is currently 62, while Harris is 49 and Rowan is 51. The decade-plus age difference and two decades of leading Apollo with Black provide a great deal of certainty that Apollo will continue to be run capably and its investment decisions made in a consistent manner for years, if not decades to come. We see the recent departure of Marc Spilker, who was president and part of the executive committee, as a nonissue. Spilker helped run Apollo's day-to-day operations and was of great assistance in helping the firm make the transition to a public company. But he wasn't involved in investment decisions, and the departure doesn't appear to be difficult, as Spilker will stay on board as an advisor until the end of 2014.
Stephen Ellis does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.