Description

Apollo Global Management, LLC (APO)

Summary

• APO is value focused: “We seek to focus on investment opportunities where competition is limited or non-existent”
• Trading at a lower multiple than traditional asset managers even though it is in a faster growing and higher margin business
• What is the market missing? Several key executives from the publicly traded PE firms have identified investors’ lack of understanding of how to value these businesses. We believe this is similar to how investors first misunderstood the investment banks when they went public.

Description

Most people here will be somewhat familiar with APO, so the description is light. The firm was founded in 1990 and has 302 investment professionals. Although most people identify APO as private equity, APO actually has three main businesses of which credit is now the largest:

Private equity: $48bn (30% of AUM)

Credit: $101bn (64% of AUM)

Real estate: $9bn (6% of AUM)

Private Equity

APO’s private equity investments are focused on opportunistic, value oriented and distressed debt driven transactions. In its last three private equity funds, APO has deployed between 28%-51% on equity buyout opportunities, 15%-31% on corporate carve-outs, and 23%-57% on distressed. On average APO has made its private equity investments at EV/EBITDA multiples lower than its peers. APO tries not to get caught up in what its competitors are doing; since inception over 80% of its PE investments have been sole sponsored where APO is the only PE firm participating in the deal. This has led to APO’s PE segment generating gross IRR’s of 39% (net 26%) since its inception in 1990; this compares favourably to top quartile 20 year PE returns of 20.2%. In its Q1 2014 10-Q, APO started to disclose Carry Eligible AUM; 91% of PE AUM was carry eligible. Although not formally disclosed, our research indicates that almost all of gains in the PE segment would be eligible to receive 20% of profits.

Credit

APO applies the same value investing philosophy to its credit investments as it does elsewhere. Since its inception, and given the founders backgrounds, APO has been heavily involved in credit. Out of the$101bn in credit AUM, $88bn is fee generating. APO’s credit funds span a range of different strategies including: Athene, US performing credit, structured credit, opportunistic credit, NPL’s, and European credit. APO discloses the performance of some of its credit funds – on average they have performed well with mid-teen net annual returns. Of the $101bn in credit AUM, approximately 36% of AUM is carry eligible. We believe that the gains in the credit segment would be eligible to receive between 15%-20% of profits.

A large portion of the credit AUM ($49bn) comes from Athene. Athene is the fixed annuity insurer APO founded in late 2008 to take advantage of the opportunity created by the regulatory and low interest rate environments. These issues were causing some insurers to sell off their fixed annuity businesses at cyclical lows.  APO used this opportunity to make several opportunistic acquisitions in the space. Currently Athene has $61bn worth of assets, its retail distribution should bring in $2-3bn per year, and it has just raised $1bn in capital with which it could possibly make further acquisitions. For further information on Athene please see the 2 most recent (2013) VIC write ups on AP Alternatives (tickers: AAA and APLVF) – an Amsterdam listed APO sponsored entity whose only asset is a large stake in Athene.

Real Estate

APO’s real estate business is relatively small. However, it has grown to where it is today in just five years without APO expending much effort. Real estate AUM is $8.9bn, with 67% of that being fee generating, and 35% being carry eligible. APO’s real estate business is mostly focused on the debt side. For those real estate funds with reported net IRR’s, APO’s performance in this segment has been in the mid-teens. We believe that the gains in the real estate segment would be eligible to receive between 15%-20% of profits.

Revenue & Expense Drivers

Since 2004 (when it expanded out of only private equity into credit), APO’s AUM CAGR has been 34%, albeit with a large portion of this attributable to some of the Athene transactions. As outlined above not all AUM is created equal; some is fee generating and some is also carry eligible.

APO breaks down its revenues into Management Business Revenues (those from management fees, net interest income, and advisory & transaction fees) and Incentive Business (derived from its carry eligible AUM upon performance). Its Management Business Revenues have grown steadily, since 2005, at a CAGR of 25%. As we would expect, as APO has expanded into credit, the management fee as a percent of fee generating AUM has decreased; it generates about 0.92% in its private equity division and 0.57% in its credit division.  In 2013, credit, private equity, and real estate represented 56%, 38%, and 6% of Management Business Revenue, respectively. Approximately 96% of AUM was in funds with a contractual life at inception of seven years or more, and 7% of their AUM was in permanent capital vehicles with unlimited duration. This management fee oriented stream of revenue is highly desired by the publicly listed PE firms as they are well aware investors like to see recurring revenue as it is substantially easier to place a value on than unpredictable cash flows. Over the last four years APO’s expenses, associated with its management business, have averaged 78% of revenues, this should be a good approximation but realistically there should be some further economies of scale.

As many have read, Leon Black was infamously quoted last May as saying that APO is selling everything that’s not nailed down. Mr. Black reiterated those views on the company’s most recent conference call. This has drawn attention to the cyclical component of APO’s incentive business. As outlined above, only $83bn is carry eligible; 91% of private equity, 36% of credit, and 35% of real estate. We believe that APO’s incentive participation on its carry eligible AUM is 20% in private equity, 15-20% in credit and 15-20% in real estate. Approximately 40-45% of the incentive received by APO is apportioned away as incentive compensation to its investment professionals (just less than half of this is in APO stock).

Valuation

In our valuation exercise we approached APO as a three to five year payout business as it essentially does not require much capital. With this in mind and with some conservative assumptions, we looked at the different average payout scenarios for APO over a cycle.  Two examples are illustrated below; slide the returns assumptions to generate more.

Example one - well below average returns for all businesses.  Starting with the incentive business, we assume APO’s average returns over a cycle are:  15% in its private equity funds (vs 26% historical), 6% in credit (vs mid-teens historical), and 4% in real estate (vs mid-teens historical). Based on the above outlined carry eligible AUM, performance fees, and incentive paid to APO employees, these returns would suggest incentive income of $911mm per year for the cycle.

Using fee eligible AUM to calculate the management revenues, we assume management fees average 0.9% in private equity, 0.5% in credit and real estate. Our management revenue forecast does not include transaction and advisory fees or interest income which would be additive to our estimate. Based on the average historical expense margin (as outlined above) we forecast $171mm of management income.

Before tax income would come to $1.1bn; assuming a 20% tax rate (vs a low double digit tax rate over the last few years) after tax income is $866mm or $2.19 per share (there are about 395mm fully diluted shares; ~139mm Class A, ~234mm held by Apollo Operating Group, and ~21mm RSU’s). The company has stated that their plan is to payout the majority of income.  Using a historical average we assume an 82% payout ratio on income leading to a $1.80 per share dividend. This would equate to a cycle yield of 6.44% based on the current share price. We believe this is attractive (more so a week ago), given our very conservative estimates, for a very high quality business run by very experienced management with one of the best track records in the business.

Example two – typical returns.  If we were to use historical return numbers and leave all other inputs the same, we would arrive at a $3.17 dividend or 11.34%. We believe our estimate to be conservative given APO’s long track record. Additionally, the dividend yield approach of looking at APO does not take into account any growth in AUM. Although we realize that with increased AUM returns would most likely decrease, but as our conservative case shows the business looks very attractive at the current price even with significantly reduced returns in all of its business segments. For some context, APO has grown its AUM at a 34% CAGR since 2004, with a large part of this growth coming from the lower margin credit division. We believe Blackstone’s AUM which is ~$270bn, demonstrates that there is room for APO to grow AUM and maintain good returns.

Although last year was a fantastic year for APO’s monetization of its private equity investments, for historical context, since the IPO in 2011, APO has distributed $8.96 per share. APO is one of the most balance sheet light publicly traded private equity firms meaning it invests relatively little of the company’s capital into its own funds. At year end 2013 APO had net debt, net accrued carry and investments in APO funds of $5.62 per share.

Summary

• Well-run company with entrenched franchise in PE and credit markets
• Opportunity exits due to APO being part of a new industry in the public markets, which is not well understood with lumpy cash flows
• Market is ignoring the recurring cash flows as APO moves away from pure PE play
• Five year distribution type investment with APO yielding well above comparables.  Consider five and ten year US B rated financials yield 5.10% and 5.76% respectively.  While five and ten year US A rated financials yields 2.23% and 3.56% respectively.  APO’s own ten year debt pays an investor about 4% annually.
• Increasing predictable recurring cash flows backed by long duration sticky money
• Strong balance sheet with management committed to paying out income (limited investment at the company level)

Risks

• Even before Blackstone’s IPO in 2007, a Blackstone tax has been widely discussed. This tax would essentially look to tax carry income as regular income and not as capital gains. Additionally, since publicly listed private equity companies are pass through vehicles where they don’t pay ‘corporate’ tax if cash is distributed, there is also consideration to eliminate the pass through nature of the entities which would have a meaningful and negative impact on holders of the stock.   We believe today’s valuation reflects this uncertainty.

• Inevitably, APO’s business will be affected by the ebbs and flows of the capital markets. Although the outlook for APO’s business may oscillate with these gyrations, we believe our conservative assumptions demonstrate that over the cycle APO will generate an attractive return.

• Recently, some attention has focused on some of the insider selling. The founders are allowed to sell 7% per year starting in 2013, until 2015 when the lock up ends. Josh Harris, one of the founders has recently been selling under a 10b5-1 plan.  Although, both Josh Harris and Marc Rowen have sold some stock in the last 12 months, Leon Black has not sold any of his holdings. In our opinion, we do not think that the recent insider sales are cause for concern.

Catalyst