Market Volatility for Asset Managers Creates Opportunities
The difference between traditional and alternative managers affects how we treat them in a downturn.
In volatile market conditions, the shares of both traditional and alternative asset managers tend to move substantially, reflecting investor uncertainty over the impact that the market's movement will ultimately have on earnings. We think it is worth noting the differences between the traditional asset managers, where the impact of market volatility is more observable and immediate, and the alternative asset managers, where the impact of market volatility tends to be less observable and, in our view, the managers tend to be less sensitive to it than most investors believe. In the current environment, we consider BlackRock (BLK), Blackstone (BX), and Apollo Global Management (APO) to be our top ideas.
This difference between the two groups has an impact on how we treat them in a market downturn similar to the one we've seen since the middle of August. We have taken down our fair value estimates of most of the traditional asset managers, including BlackRock. We have not, however, changed our moat ratings for these firms, as these are normal mark-to-market adjustments that we make from time to time (which happen to have a larger impact on our estimates during market rallies or downturns that take place in a short period).
As for the alternative asset managers, our analysis of market volatility exposure for the group suggests that the impact on their levels of assets under management should be less dramatic, with any changes to our fair value estimates occurring because a company like Och-Ziff (OZM), where we've already reduced our fair value estimate, has more exposure to assets that are highly correlated with the global equity markets. The gap that exists between the trading multiples of the traditional asset managers and the alternative asset managers tends to widen during market downturns, providing investors with an even better opportunity to take advantage of the disparity that exists between the trading multiples of the two groups.
Where an asset manager's AUM is today has a big impact on where it will be five years from now, which encompasses the average length of the projection period we lay out for both the traditional and alternative asset managers. As such, when the market rallies or declines in an extremely short period, we are compelled to adjust our fair value estimates to account for the impact that the market volatility is having on our long-term forecast of AUM, revenue, and profitability, as near-term market gains/losses and inflows/outflows tend to reset the base level of AUM we are working with in our valuation model. The impact tends to be greater for the traditional asset managers, who tend to make ongoing mark-to-market adjustments, than for the alternative asset managers.
For the traditional asset managers, the vast majority of their AUM is held in mutual funds and separate accounts, which are marked to market on a daily basis, with market changes and inflows and outflows having a more immediate impact on overall AUM levels. While one would be correct in believing that this would have an effect on near-term revenue and profitability, the full impact is dictated by (1) how a company calculates its average AUM (one of two key components of management fees) and (2) the dispersion of its AUM over different asset classes and client types. For example, T. Rowe Price (TROW) charges fees based on average daily AUM levels, rather than monthly or quarterly averages, which means the impact on its revenue and profitability is more immediate than it is for its peers when the market either rallies or declines in a short time, much like we've seen this month.
The overall impact of a market downturn on a traditional asset manager's AUM also depends on the breadth and depth of the product portfolio. For example, in the current market downturn, where U.S. stock markets have declined around 10% in less than a week, firms with heavier exposure to actively managed equity funds are going to experience both market losses and outflows (as actively managed U.S. equity funds have already been in net outflow mode for more than 10 years now). Companies with larger fixed-income and money market platforms should do better, as investors have traditionally sought the safety of these asset classes during equity market downturns. That said, there are some fixed-income offerings, like Templeton Global Total Return at Franklin Resources (BEN), that have underperformed dramatically and account for a larger portion of a firm's exposure to the asset class.
Firms with greater exposure to the institutional channel, like BlackRock (which garners about 83% of its AUM from institutional clients, by our calculations), tend to hold up better in market downturns, as these types of clients (along with retail-advised and, more specifically, high-net-worth clients) do not cut and run when the markets get volatile. This should limit losses primarily to market depreciation. That's not to say that there won't be outflows at BlackRock, it's just that the redemptions are likely to be less dramatic than at firms with greater amounts of retail exposure.
In contrast to the traditional asset managers, the alternative asset managers do not offer daily liquidity within their funds, with fund lockup periods stretching out for as long as a decade in most cases. Some exposure to public stock market volatility does exist across our coverage universe, but it varies from company to company, making it difficult to make the quick kind of judgments that are more prevalent with the traditional asset managers. Most alternative managers see the immediate impact for the hedge funds they run, with Carlyle's (CG) (Claren Road) and Fortress' (FIG) macro funds seeing particularly weak performance recently and, in turn, significant redemption, though the level of AUM involved here is typically a fraction of their overall AUM. For the alternative asset managers, we think the best way to gauge this public market exposure across all of their asset classes is to look at each company's percentage breakout by investment classification level, with assets categorized from Level I (based primarily on market quotes and thus more susceptible to market volatility) to Level III (where value is less likely to gyrate, as much as it is based on management's assessment of value). In most cases, Level I assets would include listed equities and mutual funds that are more apt to reflect market conditions, whereas Level III assets would be private equity and real estate funds, collateralized loan obligations, and credit-focused funds, which are far less likely to vary too significantly during a period of stock market volatility.
With that in mind, we've separated the eight alternative asset managers we cover into two groups. The first group comprises Apollo and Och-Ziff, where we estimate that 27% and 32% of their portfolios, respectively, are classified as Level III investments. This is the lowest in our coverage universe, which implies to us that these two firms are the most exposed to public market volatility. For Apollo, the main contributor to its greater amount of Level I exposure is the AUM it sources from Athene, which is primarily invested in publicly traded fixed-income securities. While this AUM is more volatile, we'd note that unlike most funds, it is permanent capital and thus Apollo won't see outflows from Athene. With Och-Ziff, the lower level of Level III assets is driven by the exposure of its multi-strategy hedge fund, which typically pursues public investments. In the other group, Fortress, Oaktree (OAK), KKR (KKR), Blackstone, and Carlyle all have more than 56% of their AUM classified as Level III, and we estimate that Ares (ARES) (given its credit focus) has about 99% of its investments classified as Level III. As a result, we'd consider this group of companies to generally be about a third to half as volatile as the traditional asset managers in market dislocations, with Ares seeing very little impact from increased global stock market volatility.
Another approach to gauging the exposure of the alternative asset managers is to focus on the percentage of management fees that a firm derives from funds on a net asset value pricing structure. There are a variety of ways for management fees to be earned by the alternative asset managers, including a percentage of AUM basis, a NAV approach, and a percentage of committed or invested capital structure. Management fees earned on NAV are the most likely to be affected by changes in the value of the underlying assets and thus are the most volatile in market dislocations. In our coverage, we believe Fortress, Apollo, and Och-Ziff are the most exposed to this phenomenon, with roughly half of management fees at Fortress and Apollo (mostly due to Athene) and around 70% of Och-Ziff's management fees collected on a NAV basis. In contrast, the remainder of the group has only about a third of their management fees based on a NAV approach, with Ares (again due to its credit focus) having the lowest exposure in the group at around 2% of management fees.
What this tells us is that while the more traditional asset managers will see a greater portion of their fees affected by public market volatility, leading to more changes in our fair value estimates in periods of increased volatility where markets rise or fall dramatically in a short amount of time, a vast majority of the alternative asset managers we cover would see far less management fee volatility, given the structure of their investment portfolios and management fee agreements, making it less likely that the group would see the same level of mark-to-market adjustments that we are making for the traditional asset managers. That said, there are going to be values in both groups of managers during a market decline, as investors tend to overshoot on the downside, providing good entry points for long-term investors.
Greggory Warren does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.