Finding Value in Alternative Asset Managers
Many of these misunderstood firms are currently undervalued.
We believe that the alternative asset management industry is structurally attractive and misunderstood by investors. The relative newness of the industry to the public markets--not to mention the complexity of its accounting--has kept many investors from looking at the group more closely. In our view, investors don't fully appreciate the business quality or growth prospects of the best alternative asset managers, many of which have expanded far beyond their roots in private equity.
What Are Alternative Asset Managers?
Alternative asset managers invest in nontraditional asset classes on behalf of pension funds, endowments, foundations, and other institutions, as well as high-net-worth individuals. Many of the industry's largest players--such as Blackstone, Apollo, and Carlyle--started off in private equity but have expanded their offerings to include credit, real estate, secondary funds, and funds of funds. Other firms--like Oaktree and Ares--have focused almost exclusively on credit opportunities.
Most alternative asset managers are structured as partnerships, which file K-1s. The investment managers themselves serve as the general partners, and investors in their funds are designated as limited partners. Interest in alternative asset management products has increased substantially over time, thanks to strong investment returns. We expect continued healthy growth in investor allocations to alternatives.
A typical private equity fund lasts about 10 years. The general partner identifies a promising investment niche and engages in a 12- to 24-month fundraising period when limited partners (normally restricted to professional and wealthy investors) can subscribe to the fund. Limited partners have little idea of the investments the fund could make, relying instead on the manager's record and reputation when making decisions.
Once a limited partner has committed capital to a fund, it is required to contribute this capital on demand. The manager of the fund invests it over three to five years, for example through a leveraged buyout of a publicly traded company. In the later years of a fund's life, the manager sells off its portfolio holdings and makes distributions to investors. If the performance of the previous fund was satisfactory, limited partners frequently recycle their realized gains into the next fund offered by the manager.
Value creation in private equity comes from three sources: leverage, price/earnings multiple expansion, and operational improvements. Private equity funds have seen the best returns when they put capital to work in a difficult environment, such as during the 2008-09 financial crisis, and then monetize their investments in a better environment, such as the current bull market. Funding acquisitions largely with borrowed money magnifies the effects of any operational improvements or P/E multiple expansion. On the other hand, banks and limited partners have become more reluctant to fund highly leveraged deals after a series of failures, which has increased the equity contributions required of general partners. In recent years, operational improvements have become a greater focus for private equity. The leading firms employ numerous in-house executives, consultants, and advisors with decades of industry experience who can revitalize a company through cost-cutting, acquisitions, divestitures, or other strategic maneuvers.
To diversify away from the volatile and market-dependent private equity business, alternative asset managers have engaged in a fairly aggressive acquisition spree, expanding their offerings to include credit, real estate, and funds of funds, among others. We view this as a positive, since enrolling a limited partner in multiple strategies increases the stickiness of assets under management. A more diverse business mix can also insulate asset managers from increasing competition within any given strategy.
Assets Under Management by Strategy ($ Millions)
What About Unitholders' Interests?
In 2007, alternative asset managers became publicly traded for the first time with the initial public offerings of Och-Ziff, Fortress, and Blackstone. These were followed several years later by KKR, Apollo, Oaktree, Carlyle, and Ares. The main reason for the initial public offerings was to increase liquidity for the partners, as well as to facilitate acquisitions.
Public unitholders don't have a direct ownership stake in the funds sponsored by the general partners. Instead, unitholders receive a share of the management and incentive fees and carried interest earned by the asset managers, after deducting operating expenses and capital that is reinvested in the business. Firms typically pay out 80%-90% of cash earnings to unitholders in the form of distributions.
Insiders at the publicly traded alternative asset managers generally retain the majority of units and an even greater share of the voting rights through different unit classes. Despite the lack of control over the firms, we think unitholder, limited partner, and general partner interests are aligned. Many top managers take limited or no compensation other than the distributions they receive through their unit ownership, which gives them a strong incentive to increase distributions over time. In 2008-09, insiders saw a substantial decline in the value of their units as well as sharply lower distributions, alongside common unitholders. In addition, alternative asset management firms and top executives usually make a meaningful capital contribution to their funds, which leaves a substantial part of their compensation tied to fund-level returns. Finally, senior managing directors are usually bound by noncompete arrangements, which prohibit working for a competitor or soliciting clients for at least a year after leaving a firm.
How Do These Firms Make Money?
The publicly traded alternative asset managers generate revenue in three ways: management fees, incentive fees, and investment income.
Management fees range between 0.3% and 2.0% and are commonly charged on committed capital, invested capital, or net asset value. Fees can vary greatly depending on the size of the fund, the fundraising environment, the investment strategy, or the level of capital commitment made by the limited partner, among other factors. Management fees are charged for the full life of a fund, but may be reduced in the later years when assets are sold and incentive income can be generated.
Asset managers also charge incentive fees or carried interest. For example, hedge funds typically charge 20% of the fund's capital appreciation per year, subject to a high-water mark and certain hurdle rates. Private equity funds often charge between 10% and 30% of any realized profits on an investment, subject to a hurdle rate of 7%-10%.
Lastly, in order to align their interests with the limited partners, alternative asset managers usually contribute 1%-5% of the capital to their funds, which results in investment income. These investments are held on the asset manager's balance sheet. Transaction, monitoring, and other advisory fees can also be charged. However, thanks to pressure by limited partners over the past few years, most of these fees are rebated to limited partners through a reduction in management fees.
Do Alternative Asset Managers Have Moats?
Traditional asset managers such as BlackRock (BLK) have earned economic moats thanks to switching costs and intangible assets. In our view, alternative asset managers benefit from similar advantages. We consider the following factors when assigning moat ratings to the alternative asset managers:
Fund lives. Most traditional asset managers rely on investor inertia to keep annual redemptions low. In contrast, alternative asset managers can impose lockup periods, which prevent investors from redeeming part or all of their investment within a specified time. We favor longer lockup periods because they create substantial switching costs. For example, private equity funds can limit investor redemptions for 10 years or more, which implies a great level of trust between the limited partners and general partner. In contrast, hedge fund redemptions can occur as frequently as quarterly.
Operational expertise. Large general partners such as KKR and Blackstone create value for their portfolio companies by providing operational and strategic expertise.
Fundraising expertise. The top executives at alternative asset managers play a critical role in raising new funds because of strong established relationships with institutional investors and high-net- worth individuals.
Investment expertise. Firms with a large number of experienced investment professionals operating across a broad range of asset classes have more extensive and deeper relationships with buyers and sellers, which generates higher-quality investment opportunities.
Product portfolio. Limited partners are increasingly looking to consolidate their assets with fewer managers in an attempt to reduce oversight costs. Managers that can develop and source investment opportunities across a wider range of strategies and asset classes have an easier time raising capital.
Reputation. Managers with a long and successful record of strong investment performance (preferably over decades) and a history of treating limited partners with respect are better positioned to attract capital than a startup with a limited record.
Culture. We believe Carlyle, Blackstone, and KKR have some of the strongest internal cultures and have different teams actively working together to put more money behind their best ideas. For example, Blackstone put more than $10 billion to work across the firm toward its improving housing thesis-- which was based on insights gleaned from its private equity, credit, real estate, and solutions segments-- resulting in investments in single-family homes, home automation services, credit financing, nonperforming residential loans, mortgage servicing rights, and the purchase of homebuilder and related equities.
Geographic reach. The larger an alternative asset manager's base of global offices, investments, and overseas clients, the further along it will be in developing relationships with the limited partners of tomorrow (which are increasingly sovereign wealth funds), as well as sourcing international deal flow. Carlyle is by far the leader here, with about 25% of its investments in the past few years made outside North America and Europe.
We award narrow Morningstar Economic Moat Ratings to most of the alternative asset managers we cover because of high switching costs, strong reputations, and scale advantages. Moat trends tend to be stable, as positive tailwinds such as increasing allocations to the largest managers are offset by fee pressures, demands for greater transparency by limited partners, and increasing regulatory scrutiny.
Blackstone Group (BX)
Blackstone is the only alternative asset manager we consider to have a wide economic moat. The firm is the largest and most diversified player in its industry, with the strongest record of strategy innovation and fundraising. Blackstone is unique among alternative asset managers in that it has scale across multiple asset classes: real estate, private equity, credit, and hedge fund allocation. It is nearly always a contender for new assets, as it has access to more than 1,300 limited partners and more than 900 investment professionals. Furthermore, we estimate that 60%-70% of Blackstone's limited partners invest in more than one fund, indicating strong cross-selling ability.
Carlyle Group (CG)
We believe Carlyle has a narrow moat, as its product offerings, limited partner relationships, fundraising, and in-house expertise would be hard to duplicate. While the firm's fundraising has trailed Blackstone's during the past few years, it has been far more aggressive in pursuing global expansion: adding new region-specific funds, opening offices overseas, and developing relationships with foreign investors.
Apollo Global Management (APO)
Switching costs and a strong reputation in credit and private equity give Apollo a narrow economic moat, in our view. We consider Apollo the best-positioned alternative asset manager to benefit from the secular shift of riskier assets from banks to nontraditional lenders. With more than $100 billion of credit assets under management, the firm has deep expertise in valuing complex and illiquid credit securities. About 40% of Apollo's AUM comes from Athene's fixed-annuity operations, which create a stable base of assets that will not demand redemptions at inopportune times, a substantial advantage over peers.
KKR was one of the founders of the modern private equity industry and has nearly four decades of experience. KKR's 10 largest investors have remained with the firm for almost 20 years, and more than half of new capital tends to come from existing KKR investors. The firm differentiates itself from peers by using its balance sheet to make large investments in its own funds and by applying operational expertise to turn around its portfolio companies.
Oaktree Capital Group (OAK)
Oaktree is one of the most respected and experienced alternative asset managers in the credit markets. We believe the firm's client-first approach has engendered unusually strong client loyalty. Oaktree routinely has to turn down billions of capital. Insiders own 72% of the firm's outstanding units, and top executives receive no compensation other than distributions from their unit ownership.
Ares Management (ARES)
The bulk of Ares' assets under management is dedicated to credit strategies, with a particularly strong direct lending platform through business development company Ares Capital. With regulators putting pressure on traditional banks to restrict lending to highly leveraged entities, Ares can pursue deals that competitors might struggle to fund. While smaller than peers in private equity, Ares has enjoyed fundraising success, with its latest fund oversubscribed within six months.
Och-Ziff Capital Management Group (OZM)
We don't think Och-Ziff has an economic moat. The firm's heavy reliance on hedge funds results in assets under management that are less sticky, while competition is intensifying in increasingly commodified hedge fund strategies. Furthermore, we think Och-Ziff lacks the diversification or scale necessary to meet the needs of institutional investors that are looking to consolidate their relationships with fewer alternative asset managers. Och-Ziff's fundraising has been the weakest among peers in recent years.
Fortress Investment Group (FIG)
We don't believe Fortress has an economic moat either. Poor investment performance during the financial crisis soured Fortress' reputation with limited partners, and the firm has been unable to raise a new general private equity fund since 2007. Furthermore, Fortress could see about a third of its alternative assets under management liquidated within the next five years as lockup periods expire. The firm also suffers from a limited product portfolio, narrow geographic reach, and fewer investment professionals than peers.
Stephen Ellis does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.