Description

Summary

Apollo (“APO”) is one of the largest alternative asset managers in the world with over $300 billion in assets under management. Athene (“ATH”) is the number one underwriter of retail annuities in the US with over $150 billion in assets under management. On March 8^th, 2021, the two companies agreed to merge in an all-stock transaction. The transaction is slated to close in January 2022 (two months from now). I believe the closing of the transaction will be a major catalyst that will narrow the discount of the pro-forma APO-ATH entity to peers, driving 40% upside in the short-term, on today's numbers.

Managing 3rd party private AUM is one of the best business models ever created. While I suspect the discussion on VIC will center around the near-term opportunity, I believe APO is more than just a simple re-rate.  At a recent investor day, management spelled out a very compelling growth plan. The company is guiding to normalized earnings growth of ~13% / year and also guided to $15 billion of free cash flow distributable to shareholders over the next 5-years. This implies a ~7% cash on cash yield after planned reinvestment for growth. Earnings growth plus capital generation available for distribution to shareholders implies a ~20% / year return before multiple expansion. Credit management with smart capital allocation and the aforementioned multiple expansion, it's not hard to see APO generating a >20% IRR over the medium-term. APO is a name you can own in size, with duration. 

The primary reason this opportunity exists is due to the complexity surrounding the current all stock merger. Once the merger closes in January 2022 and we begin to see APO-ATH report as one consolidated entity, the market will begin to better appreciate the pro forma earnings power of the business. The street has yet to fully update its numbers as the merger has yet to close. I expect a material revision post-January 2022. Similarly, coverage is still being worked out on the buy-side and sell-side given that Apollo and Athene were likely covered by two-different analysts.

Post merger: i) APO will be one of the fastest growers in its comp group at the lowest valuation; ii) APO will be moving to a single share class structure ("one share one vote") versus peers which are all dual-class listed; iii) APO is expected to have best-in-class ESG metrics (we expect a strong revision in its ratings from the ESG analysts like Sustainalytics); and iv) APO will be a top candidate for S&P 500 inclusion.

To supplement this write-up, I urge everyone to watch APO's investor day presentation on October 19, 2021 (https://www.apollo.com/stockholders/events-and-presentations/2021/19-10-2021). In particular, watch CEO / co-founder Marc Rowan's section. Marc delivered one of the best investor presentations I have ever seen. This is not someone you want to bet against! 

All-in-all, Apollo is a dream VIC investment. You get to own the GP of a value manager, led by one of the best minds in the business, with best-in-class governance, in an industry with numerous tailwinds (managing private AUM), at an extremely attractive valuation, with several near-term catalysts.  

Situation Overview

Athene was founded in 2009 by its current CEO, Jim Belardi. Belardi spent his entire career in the annuity business, initially building SunAmerica alongside well respected entrepreneur Eli Broad. In 1998, SunAmerica was sold to AIG for >5x book.

The primary goal of Athene was to capitalize on dislocations in the life insurance industry created by the financial crisis. The financial distress from the crisis and resulting capital demands caused many companies to exit the market, creating the need for a well-capitalized company with an experienced management team to fill the void.

Apollo funded the initial formation of Athene and in addition, provided several services to the company. Apollo was the sole manager of Athene’s general investment account through an external management agreement, while Belardi and team were largely responsible for sourcing the float for Apollo to invest.

The Athene – Apollo relationship had early success. During Athene’s founding years, Apollo created most of the value on the investing side of the business. For example, the Athene entity was a major early investor in distressed non-agency RMBS. By the end of 2010, Athene acquired a portfolio of ~$450 million (which was ~25% of total invested assets at that time), well in advance of the significant price improvement in these investments.

As time progressed following the financial crisis, asset price dislocations became less prevalent. However, fortunately for Athene, life insurance companies were still keen on divesting their capital-intensive business segments. In turn, this created an attractive avenue for Athene to gather assets. Most notably, in 2013, Athene acquired Aviva USA. This transaction gave Athene increased scale and meaningful new business capabilities in the annuity space, helping create one of the largest fixed annuity platforms in the United States.

Athene continued to grow via organic and inorganic opportunities, ultimately IPO’ing in December 2016. Athene IPO’d at $40 per share and within six months, traded to the mid-$50s, implying a valuation of 1.6x book and 12x earnings.

Over the course of its life as a public company, Athene completed three large-scale acquisitions:

• June 2018 – Closed a transaction with Voya to reinsure $19 billion of fixed and fixed indexed annuity liabilities. This transaction brought Athene’s total invested assets to approximately $100 billion, crossing a major milestone as a public company.
• December 2018 – Agreed to reinsure an 80% quota share of a $9.6 billion in-force block for fixed deferred and fixed indexed annuities from Lincoln Financial Group.
• June 2020 -  Reinsured $27.6 billion of Jackson National Life Insurance (a subsidiary of Prudential plc) in-force book of fixed and fixed index annuity liabilities. This was Athene’s largest acquisition.

As a result of these transactions, combined with positive organic growth trends, Athene has been able to grow book value (ex-AOCI) by ~100% since its IPO, translating to a ~17% CAGR. Unfortunately for Athene shareholders, despite this strong underlying fundamental performance, Athene has materially derated and underperformed its direct peers and greater market.

As Athene grew, the market became more and more skeptical, particularly questioning the external management contract with Apollo. While exact terms of the external management contract are not public, we estimate Apollo earns ~45 bps for every dollar of Athene’s investible assets. Therefore, there is strong incentive for Apollo to desire that Athene grows rather than focus on profitability.

Athene’s management team reiterated several times to the market that its business was better off with this Apollo relationship and that Athene was a shareholder first entity. Management took several steps to close this perception discount. For example, in 2019, Athene initiated a share buyback program, repurchasing ~10% of it’s stock. While accretive for shareholders, this buyback failed to improve the market’s perception of Athene and the stock continued to trade in the 0.7-0.9x book area post the buyback announcement.

Still dissatisfied with the share price, in late 2019, Athene’s board set out to make the following changes in order to help close the discount:

·     Eliminate Athene’s multi-class structure - eliminating Athene’s multi-class structure would increase alignment of Apollo’s voting and economic interests in Athene

·     Have Apollo take a larger equity stake in Athene at a premium to the prevailing market price – this would represent a strong, public commitment to Athene by Apollo that would enhance the alignment of interests between the two companies. Post this transaction, Apollo owned an incremental 15% of Athene, bringing its total ownership interest in Athene to ~34%.  

·     Have Athene receive a stake in Apollo – In exchange for Apollo’s interest, Athene received approximately 7% economic stake in Apollo (in addition to $350 million cash), providing meaningful participation in Apollo’s results.

These transactions closed in February 2020, right before the onset of the pandemic. However, like many capital market sensitive financials, Athene experienced a share price decline of >50% and didn’t recover until the beginning of 2021. Athene also lagged the broader market and direct financial peers.

This share price performance was contrary to the underlying fundamentals of Athene. Athene had a record 2020, with organic growth (net inflows less net withdrawals) driving >10% YoY change in net invested assets. In addition, the June 2020 Jackson National block reinsurance transaction was Athene’s largest ever on record, adding another 7% to balance sheet AUM and closer to ~20% YoY AUM when accounting for capital raised in third party vehicles.

Athene’s largest shareholder, Apollo, had a similarly successful 2020, with significant alpha generating investments made in the first half of the year and better than expected realizations in the second half of the year. However, majority owner Apollo also lagged the broader market recovery and traded at a substantial discount to direct alternative asset manager peers.

This relative underperformance of both Apollo and Athene spurred a meeting between Apollo CEO, Marc Rowan and Athene’s CEO Bilardi in February 2021.  While a merger between the two entities has been loosely discussed for nearly a decade, the relative underperformance of the two entities ultimately catalyzed a more formal discussion. 

On March 8^th, 2021, Apollo and Athene announced to merge in an all-stock transaction. The initial deal valued Athene at $11.0 billion, which implies a price-to-book of 0.9x as of Q1-21 and a normalized price to earnings of 5x not including the potential redeployment of Athene’s substantial excess capital.

The core nearer-term thesis in Apollo – Athene at the current trading price (~$70 / share) is as follows:

1.      The pro forma earnings power of Apollo – Athene is undervalued

2.     There is a significant excess capital deployment opportunity at legacy Athene that can be better be addressed under this new merged entity

3.     Apollo is currently entering a large realization cycle of mature private equity investments, which will drive significant performance fees

Should this thesis materialize, I see a path for the pro-forma Apollo-Athene entity generating over $6 per share in distributable earnings exiting 2022.

What does this merger accomplish?

The combination of Athene and Apollo creates 100% alignment between the two entities and its shareholders. In turn, the combination of these two companies should close the public markets discount both have experienced.

·     Alleviates market’s concern of Apollo’s desire for Athene’s growth - When Athene was a standalone entity, it had to contend with balancing shareholder returns versus acquiring legacy insurance liabilities given the market’s skepticism around its alignment with shareholders. Now, Apollo can fully pursue Athene’s inorganic growth opportunity and redeploy Athene’s excess capital.

·     Athene represented ~40% of Apollo’s AUM and ~30% of its fee related earnings – Following this transaction, Apollo-Athene’s management relationship will be in place into perpetuity. Therefore, this removes any concentration / contract duration concerns surrounding Apollo’s fee stream.

·    This transaction will consolidate Apollo’s ownership of Athene – Pre-deal announcement, Apollo owned over >$2.5 billion in Athene market value which it believes it was not getting credit for. Now, earnings will be fully consolidated.

Legacy Athene Normalized Earnings Power

Athene is a spread business. It uses insurance float and debt to raise AUM and invests that AUM at a spread. The spread is generally locked-in at the time of capital deployment, leaving AUM growth as the primary go-forward growth lever for Athene.

As of Q3-21, Athene has net invested assets of ~$165 billion. Organic AUM has historically grown at 7% / year while inorganic initiatives has been driven AUM growth of 11% / year. If I just credit Athene for organic growth, 1-year forward I conservatively see ~$180 billion of AUM exiting 2022e.

Athene has historically earned an after-tax ROA of 1% through all different rate environments. This spread has historically been stable as Athene can adjust pricing to maintain profitability and has been able to generate attractive yields through proprietary credit origination.

$180bn in AUM x 1% ROA = $1.8bn. The pro forma APO-ATH entity will have 600 million shares outstanding, implying $3.00 / share of normalized earnings power from Athene.

Apollo intends to double the size of Athene over the next five years and clearly spelled out the drivers at its recent investor day. Not only do I believe this growth is achievable but I believe under Apollo’s ownership, Athene will experience a large perception change. Simply put, under Apollo’s consolidated ownership, the market will now be able to look past Athene’s conflicted external management contract and better appreciate the overall resiliency of Athene versus the broader insurance universe:

·    No significant mortality or morbidity risk at Athene – A key differentiator for Athene versus other insurance companies is that it is built purely around spread income products and has no significant mortality or morbidity risk.

·    Portfolio has had less impairments than peer portfolios – Athene has averaged 8 bps impairment charge over the past 5 years versus life insurance peer average which is nearly double.

·    Balance sheet can manage a “deep recession” scenario – On March 25, 2020, at the depth of COVID sell-off, Athene published a presentation highlighting the resiliency of its portfolio. Under a “deep recession” scenario, which assumes the equity market declines ~50% and housing market declines ~25%, Athene believes there would be no external capital required and the total losses would be equal to approximately one and a half years of Athene’s capital generation.

Athene operates an A+ rated insurance subsidiary, with less insurance risk than peers, has managed investment risks better than peers, earns a higher ROA and ROE than peers, yet is trading at an implied valuation under this pro forma entity at a material discount to peers. 

Legacy Apollo Normalized Earnings Power

Recurring fees

Bridging from Q3-21, we see total fee-related earnings of $300 million. At the investor day, Apollo spelled out how it sees 18% / year growth for this business over the next 5-years. This is largely attributable to AUM growth, operating leverage and some reallocation of employee expenses away from recurring fees towards performance fees.

$300 million x 18% growth x 1.25 years forward x 4 quarters = $1.77 billion. Tax effected at 18% (guided) gets you to $1.45 billion. Divided by 600 million pro forma shares outstanding gets you to $2.40 / share of recurring fee earnings.

Performance fees

Apollo’s performance fees are predominately driven by its mature private equity business. Given the buoyant market conditions, Apollo has significant unrealized performance fees, the majority of which are expected to be realized over the next 24-months. In particular, Apollo’s Fund VIII and Fund IX, which are a 2013 and 2018 vintage fund, respectively, have an estimated $9+ billion in unrealized embedded capital gains.

If we just credit APO shareholders the performance fees from these two funds, we can see >$0.80 / share in distributable earnings ($9bn x 20% carry x 35% shareholder take x 18% tax / 600mm shares). Amortize that over the next 2-years and you get an incremental ~$0.40 / share.

If we roll forward APO’s AUM and make normalized MOIC assumptions and assume APO shareholders take ~35% of carry (with ~65% going to employees), then we arrive at a normalized ~$0.25 / share in performance fees. This assumption plus Fund VIII and IX fees gets you to ~$0.65 / share in performance fees exiting 2022e.

APO’s normalized base fees of $2.40 plus clear-line-of-sight of performance fees exceeding ~$0.60 per share gets you to ~$3.00 / share in earnings power from legacy APO. Combine this with the aforementioned ~$3.00 in earnings power from ATH and we can clearly see ~$6.00 in normalized earnings exiting 2022e.

What is the APO-ATH pro forma entity worth?

If you're interested in this idea, I suggest getting your hands on the Apollo - Athene merger research report from Autonomous (Bernstein) titled "Olympus Mons, not Molehile". In this report, the analysts do a good job benchmarking APO to everyone's beloved KKR. The key takeaway from this benchmarking analysis is that Apollo's earnings mix (earnings derived from capital intensive activities vs. non-capital intensive activities) is in-line with KKR and therefore APO should be valued at least in line with KKR. 

I emphasize "at least" as I’d argue the new pro forma Apollo - Athene entity should trade at an even higher multiple than KKR:

·    Apollo’s balance sheet intensive earnings are lower-risk than KKR- Apollo’s balance sheet mix towards lower risk, largely investment grade, securities with locked-in spread is less risky than KKR’s more PE-oriented balance sheet, and therefore should command a higher multiple.

·    Apollo has longer-term AUM – Over 60% of Apollo’s AUM is perpetual / indefinite versus ~40% of KKR’s.

·    The new Apollo entity will be a single share voting structure – KKR has a dual-class share structure with the public entity having inferior voting rights. Dual-class voting structures limit the investible universe and are typically looked at less favourably by index committees.  

·    The new Apollo entity will have a higher dividend yield – The new Apollo entity will have a fixed dividend of $1.60 / share, which implies a ~2.25% yield on its current share price versus a ~1% yield for KKR

If we value APO's one-year forward earnings power ($6 / share) by KKR's 1-year forward multiple of 17x, we can get to >$100 / share. This represents ~40% upside from today's share price. This represents a significant margin of safety for a business that is conservatively expected to grow ~20% / year from here and earnings are ~85% comprised of recurring sources. I believe APO is a position one can own in size, with duration and is investible for all funds given that it’s on it’s way to becoming a large-cap. Happy to discuss more on legacy APO/ATH performance and future business drivers in the comments section. 

Catalyst

-Merger closing in January 2022 and concurrent dual-share structure collapse

-Estimate revisions

-ESG rating revisions

-S&P500 index inclusion