Description

Athene Holding (NYSE:ATH) – Short Recommendation – Target Price of $33 (~ 40% downside)

Thesis Overview:
Athene is a compelling short opportunity at its current valuation of ~ 1.6x Price/Book ex. AOCI / ~ 13x 2017 P/E; the business is substantially overvalued in the context of the valuation of peer life insurance companies, and the risks inherent in its business model. While the market views Athene as a growing business with structural competitive advantages, in reality it is a declining business in the absence of aggressive product pricing, coupled with an aggressively structured operating model that is largely unproven and subject to a litany of risks. While trading at a large premium to book value and to the relevant comps, Athene has all of the elements of a business with poor fundamental prospects: it sells products to customers that do not want them and do not benefit from them by utilizing large commissions, is conceivably being run to maximize fee-earning AUM for Apollo rather than long term book value, is structured very aggressively with a lot of affiliated entities (similar to other complex financial enterprises which have faced compliance and accounting difficulties), and is operating in an industry with poor fundamental economics. There are numerous catalysts that could drive a substantial decrease in its market value in the next 1 – 2 years: continued declining operating ROE’s due to aggressive product pricing in recent years; inability to sustain rapid growth model; IRS / insurance regulators scrutinizing Athene’s aggressive tax / capital structure; continued selling of Athene shares by original investors in Apollo Alternative Assets as IPO lock-up expires; material accounting or control issues.

Business Overview:
Athene is a life insurance roll-up formed in 2009 by Apollo to take advantage of a large dislocation that occurred in the U.S. life insurance industry in the midst of the global financial crisis. Athene has executed several large transactions whereby it either reinsured legacy insurance liabilities that other companies wanted to shed or outright purchased companies. The company has acquired liabilities backed by ~ $66bn of assets through reinsurance / M&A. The largest such transaction was Athene’s purchase of Aviva’s U.S. Insurance Business for consideration of ~ $1.55bn relative to statutory book value of ~ $2.7bn; the deal added ~ $35bn of fixed annuity liabilities to Athene’s balance sheet (relative to total liabilities of ~ $80bn at year-end 2016). Athene substantially expanded its presence in the retail life insurance market in 2016 with the launch of several new products and several new channels.

Industry / Product Overview:
The life insurance industry in the U.S. has materially changed over the past few decades; whereas historically it was focused on selling classic life insurance products that protect against an untimely death, it is now largely focused on retirement products which are financial / spread-driven in nature, and do not rely as much on mortality risk (i.e., the primary risks life insurance companies are taking have to do more with policyholder behavior, equity market performance, interest rate scenarios, etc.). Many players in the space have been plagued by legacy liabilities taken on in higher interest rate environments, as well as by poor underwriting decisions made based on overly optimistic assumptions (i.e., many companies have been plagued by long-term care policies that they substantially mispriced due to poor assumptions around increases in health care costs over time). The initial dislocation of the industry provided an opportunity for new players backed by private equity to enter the space – these companies have both assumed legacy liabilities at a discount and taken substantial market share in the retail insurance business. Many players in the industry have struggled to achieve their targeted ROE’s; some steps they have taken to attempt to improve their ROE’s have been higher leverage, increasing investment risk (credit, liquidity, or rate risk), as well as utilizing contractual levers to decrease benefits being paid on legacy liabilities (many of these options were previously avoided because though they are contractually permitted, there is an expectation among policyholders that they will only be utilized in extreme environments). Whereas leverage among commercial banks and investment banks has decreased significantly post-crisis, many life insurance companies are operating with the same or higher leverage post-crisis.

"And in the insurance industry, we saw AIG needed a rescue. We saw Hartford struggle, Lincoln Financial. If it hadn't been for the rescue programs run by the US Treasury and the Federal Reserve, we would have had numerous insurance companies go under. Well, the situation is only worse. Basically the insurance industry is where the banking industry was in 2007." – Harry Markopolos (whistleblower on Madoff Ponzi Scheme) in late 2016

The two products Athene is most focused on are fixed annuities and fixed index annuities. Fixed annuities (FA’s, also known as MYGA’s or multi-year guaranteed annuities) are most similar to bank certificates of deposit (with the key difference being they generally offer higher rates given the lack of an FDIC guarantee). They pay a fixed interest rate annually which is tax deferred until withdrawal. The issuing company invests the float largely in fixed income investments and earns a spread; leverage on these products is typically quite high – often in the 10-20x range. Typically, the product offers a guaranteed rate for some number of years (i.e., 3 years, 5 years, or 7 years), and then the rate typically is reduced to a contractual minimum (usually 50bps – 100bps). A large portion of the product’s profitability comes in the tail-end, when rates are dropped and some portion of policyholders choose to uneconomically remain in their policies (or simply forget to withdraw their money and put it in a more attractive investment option). A fixed index annuity (FIA) is a relatively complicated product which offers some upside tied to an equity-linked index (S&P 500 is the most popular, but there are some other customized indices as well). FIA’s typically offer a guaranteed annual roll-up rate (i.e., guaranteed annual growth in account value / benefit base; 5% is a common rate) for a set number of years, with the expectation that the policyholder will begin withdrawing annual income from the accumulated value (benefit base) of the policy sometime around age 65. Some FIA’s include a guaranteed living benefit rider that guarantees certain payments even if the accumulated value in the policy has been depleted. The insurance company earns money both by charging annual fees on the account value and by investing the float, and purchases call options on the reference (equity) index to provide the equity upside. While the products presumably offer equity-like upside with no downside, they are costly, and in reality there are very few likely scenarios where the equity upside actually produces additional retirement income for the policyholder. Unfortunately, many older Americans purchasing these products do not fully understand them and thereby have no real way of assessing their value proposition. In a recent NY Times article discussing these products, Craig McCann, a former Economist at the SEC, said: “No agent selling these or investors buying these has the foggiest idea of how these work,” in reference to FIA’s. If annuities do not offer compelling value propositions, one might reasonably wonder how billions of dollars of annuities are sold every year.

“Suppose you’re the manager of a mutual fund, and you want to sell more. People commonly come to the following answer: You raise the commissions which, of course, reduces the number of units of real investments delivered to the ultimate buyer, so you’re increasing the price per unit of real investment that you’re selling the ultimate customer. And you’re using that extra commission to bribe the customer’s purchasing agent. You’re bribing the broker to betray his client and put the client’s money into the high-commission product.” – Charlie Munger

There is a common insurance industry refrain that “Annuities are sold, not bought”. Commissions paid on annuity products are among the highest of any financial product, approaching 5-10% for some products. Agents are thus strongly incentivized to sell these complex financial products to unsophisticated customers who lack the ability to properly understand them. Another common industry feature is agents who execute 1035 exchanges, which are transfers from one annuity to another, which often produce an economic disadvantage to the customer, but always produce an additional commission. Additionally, FA’s and FIA’s create numerous complexities in terms of accounting for them on a GAAP basis (FIA’s trigger the use of derivative accounting, and commissions paid on the both products are capitalized and amortized based on a complex formula linked to lifetime profitability projections on the products). The complex accounting provides management teams with considerable discretion and thus makes ROE’s model-driven, rather than earnings driven.

Industry Competition / Pricing:
While analysts and investors are enamored with Athene’s rapid growth (both in total liabilities and in its retail organic volumes), there are numerous reasons to be very concerned with the costs of said growth. From a classical competition theory standpoint, a financial product is a perfect commodity – all else equal, people care about only the price or interest rate (in both lending products and financial products like CD’s and FA’s) – said differently, two companies with the same credit rating can win business only by being more aggressive on the pricing side. In the context of FA’s and FIA’s, this means that companies can only win business by offering the most generous benefits (interest rate for FA’s and combination of roll-up rate, equity participation, etc. for FIA’s). While Athene has touted its rapid organic volume growth of late, many other participants in the industry have been sounding the alarm that pricing is becoming very competitive. It is worth noting that most life insurance companies target returns on equity of roughly 10-12%; Athene believes it has several competitive advantages and thus targets a mid-teens return on equity. Many investors incorrectly believe that higher interest rates will dramatically benefit life insurance businesses – this is true to some extent for margins on legacy liabilities, but new business being written is being priced aggressively as interest rates rise due to elevated competition in the market (i.e., the benefits of higher rates are flowing through to customers given the competitive nature of the business). Below are several noteworthy comments from recent competitor earnings calls as it relates to pricing:

• American Equity Life (AEL) 4Q16 Call:

• Erik Bass: Hi thank you. Given the spread pressure that the industries faced, are you surprised that pricing has moved this quickly in response to rates and just does it change your view at all on the potential to get back to historical target spreads, even if the interest rate environment continues to improve?

• John Matovina: Well certainly pricing is surprising to us. We know other companies might be willing to accept lower levels of credit quality or other approaches to generating some high higher investment deals, but that in our view Erik, doesn't support some of the differentials in rates that we see. I just have a hard time believing this as a long-term situation that, I just don't see how they can persist that those rates for an extended period of time.

• John Matovina: And you mentioned MYGA at the tail end of your question Mar; MYGA as an American equity have never been part of our strategy. They’ve been an accommodation to agents who are selling fixed index annuities and if a particular agent had a customer policyholder who wanted a MYGA policy, we wanted to at least have a policy available for that agent to place with us as opposed to forcing them to go to a competitor. MYGA policies are very rate sensitive and so the tenants of agent loyalty and relationships disappear in the MYGA space and it’s just not one that we’re interested in being in because the only way you really do have long-term success is kind of almost always have an [the] highest rate.

• Lincoln National Corporation (LNC) 4Q16 Call:

• On new business -- and Dennis mentioned this in his comments - it allows products to become -- to get adjusted in a way that makes them more attractive to consumers. You are able to offer more benefit or lower premiums which makes these products not only more attractive to consumers, but more competitive with other options they may have. So I think that's a big deal from a new business standpoint, if you can see those new sales levels move up.

Athene’s Unique Structure:
Athene targets mid-teens returns on equity, whereas many of its competitors have struggled mightily to meet their ROE targets of 10-12%. If the products Athene focuses on are commoditized, how then is Athene able to earn higher returns than almost all of its competitors while offering more generous benefits to win business? The main differences between Athene and its peers are investment allocation / portfolio, tax rate, and leverage. Athene outsources its investment management operation to Athene Asset Management, which is controlled by Apollo. Unlike many of its competitors, Athene has a higher allocation to private corporate investments and to alternatives (largely Apollo PE funds).

“I can earn almost twice the return with less risk by moving down the liquidity spectrum. For an account like Athene, that is an ideal situation. And what I like is, on the one hand, Athene's liabilities are priced relative to investment alternatives available to consumers, think CDs. So rates are very, very low. On the other hand, their assets don't have to be liquid, but they do have to be highly rated.” – Mark Rowan at the GS Financial Services Conference in December 2013

In essence, Athene has chosen to take substantially more liquidity risk than many of its peers. The risk here is that if Athene mismatches its assets with its liabilities, it can be forced to sell-off these assets at large liquidity discounts to raise funds, which could present a solvency problem in certain scenarios. It is worth noting that this decision to invest differently from the industry norms has never been tested in a financial crisis or credit shock. Athene also has a much lower effective tax rate than many of its peers which are full U.S. taxpayers. Athene reinsures 80% of its new business to its affiliated Bermuda reinsurer, Athene Life Re (AL Re).

“ALRe holds the substantial majority of our capital with $6.1 billion of statutory capital as of December 31, 2016. ALRe had a BSCR ratio of 228% as of December 31, 2016.” – Athene S-1

Athene’s usage of a Bermuda affiliate reinsurer is important for two reasons – it enables it to pay very little in taxes (effective tax rate of -7% in 2016 and 2% in 2015), and because it gives Athene substantially more flexibility in how much capital it is required to hold against its liabilities. Athene’s onshore entities are able to receive reinsurance credit and thus do not hold much capital, and in Bermuda Athene Life Re is not bound by the NAIC risk-based capital requirements – it only has to meet the Bermuda Solvency Capital Ratio requirements. There is also more flexibility in Bermuda in terms of paying dividends to the parent company. There are two reasons why the U.S. government should be concerned about this structure – Athene essentially has free reign to ignore U.S. capital requirements because the majority of its capital is in Bermuda, and Athene is paying almost no income taxes on a business that is conducted almost entirely in the U.S. If the IRS were ever to disallow Athene’s current structure, the impact would be very severe, and the business Athene has built will be worth substantially less. Additionally, it seems likely that if there were ever national regulation of insurance companies, Athene’s current structure may be disallowed or penalized.

Even despite what Athene touts as its large structural advantages, its operating ROE’s have declined rapidly in the last few years (consolidated operating ROE’s of 24.0%, 15.6%, and 12.5%, in 2014, 2015, and 2016, respectively). This is likely because Athene’s current business is no longer comprised largely of liabilities acquired in the dislocation triggered by the financial crisis; it is increasingly comprised of liabilities acquired in a heightened competitive environment over the last few years (in the life insurance business, a given year’s operating performance is largely a function of business written several years ago).

Athene’s Relationship with Apollo:
Athene was originally a private investment executed through a closed-end fund run by Apollo. Additionally, Apollo owns Athene Asset Management which charges Athene 40bps on AUM (agreement amended recently to a rate of 30bps on new assets acquired after 2016). This relationship now provides a substantial portion of Apollo’s earnings. Athene has been referred to as “permanent capital” on Apollo earnings calls. Athene’s AUM represents ~ 25% of total AUM at Apollo of ~ $190bn. Even if Apollo does source better assets for Athene than competitors are able to source, the “alpha” is being paid away in the form of fees above the industry norm (40bps is very high relative to comparable fixed-income, investment management agreements). Another concerning data point is that Apollo invested some of the Athene float in securities linked to Caesars as Caesars was going bankrupt; it should be highly concerning to regulators that an insurance company was used as a lender of last resort for an affiliated PE investment. Apollo was incentivized to maximize its carry on the AAA (Apollo Alternative Assets) closed end fund which previously owned Athene – it seems likely that Athene was being run with the sole purpose of maximizing the valuation in the IPO / period immediately following the IPO. This would explain why Athene was so focused on rapidly growing its retail insurance business in 2016. Organic deposits have grown by ~ 3x since 2014. Athene is not really a growing business, and likely would be showing organic declines if not for its aggressive pricing in 2016. For the full year 2016, Athene generated $8.8bn of new deposits, which significantly exceeded the $3.9bn of deposits generated in 2015 (4Q16 ATH earnings call). Apollo controls ~ 45% of the voting rights of Athene. These data points indicate Apollo is primarily incentivized to maximize its own economics, instead of sustainably growing Athene as a business. Apollo’s large fee stream on Athene AUM provides a large incentive to grow Athene’s AUM regardless of incremental ROE’s on new business.

Parallels to Ocwen / Dangers of Rollups in the Financials Space:
While many investors are enamored with Athene due to its rapid growth in contrast to an industry that is not growing, there are a number of structural reasons that make Athene’s business model very concerning. The business essentially has a lifespan of ~ 5-8 years because the liabilities roll-off over time – this is very similar to the mortgage servicing rights Ocwen aggressively acquired in midst of the financial crisis; it becomes harder and harder to sustain the rapid growth over time due to organic run-off of the core business. Additionally, rapid growth in an area with complex accounting and control requirements in a regulated industry can prove very dangerous. As seen in the Ocwen story, the growth has the potential to result in misstated financials and the failure to follow regulatory protocols. Athene has had four CFO’s in the last four years, and had to restate its financials in the past as a result of control issues tied to the Aviva acquisition. Further, Athene has not yet been tested for a material control weakness due to a transition period allowed for newly public companies – there is a substantial risk that it has a control weakness when filing its 2017 financials given the past issues with the financials. In a broader context, rollups in the financials space have a very spotty track record, given the accounting risks involved and the competitive pricing required to aggressively grow a business that sells commoditized products.

Excess Capital Position:
On the Athene 4Q16 earnings call, management discussed an excess capital position of ~ $1.5bn.

“With respect to capital, we calculate excess capital using a 400% RBC ratio, and we expect earnings to fund expected organic growth.” – 4Q16 Athene earnings call

There is reason to believe that the ~ $1.5bn is not really unrestricted capital that can be used to fund growth; some of the ratings agencies have their own internal capital models, which are more onerous than the RBC formula proscribed by the NAIC in certain scenarios. Said differently, Athene may need to hold a material portion of the ~ $1.5bn of “excess capital” in order to maintain its current financial ratings or attempt to receive an upgrade (ratings agencies do not like rapid growth or short operating histories in the insurance space). If a large portion of this capital is actually necessary for supporting the core retirement segment, the retirement segment deserves a substantially lower multiple as the retirement operating ROE’s that Athene points to regularly are then less relevant, and the consolidated operating ROE is the appropriate metric for judging the business.
Summary Financial Data:

Valuation:
My target price for Athene is $33, or 1.0x Price / Book ex. AOCI. Athene is most similar to American Equity Life given the concentration in a small number of annuity products, and riskier operating strategy relative to other players in the industry. AEL trades at ~1.1x Price / Book ex. AOCI, and has a much longer operating track record than Athene. Athene is an aggressive roll-up with a strategy that has never been tested in a credit shock – it should trade at ~ 1.0x Price / Book ex. AOCI given its mediocre operating ROE of ~ 12.5% and the aggressive risks inherent in the business. Further, Athene has conducted much of its M&A at discounts to book value; in the acquisition process, the assets / liabilities are generally market to fair market value. Put another way, Athene is trading at ~ 1.6x Price / Book ex. AOCI even though much of the business it has acquired was already market to fair market value. The premium to book implies there is a large runway for growth at an ROE above Athene’s cost of capital, but I believe that there will not be a lot of room for attractive growth opportunities for Athene, given the elevated competition for both organic retail business and M&A opportunities (in recent years there have been a number of private equity players that entered the life insurance market, and Chinese and Japanese insurance companies are increasingly involved in the U.S. life insurance industry). As a sanity check on valuation, Enstar Group, which arguably has one of the best track records of accretive M&A in the insurance business with a quarter century track record of slow and sustained growth, only trades at ~1.36x Price / Book. Lastly, the regression of Price / Book ex. AOCI and operating ROE for Athene’s most relevant comps implies a Price / Book ex. AOCI of ~ 1.15x for Athene.

Risks:

• Part of what makes Athene an attractive short at the current valuation is there do not seem to be many likely paths where the valuation can expand even further, especially when considering where peers trade; that being said, book value should continue to grow at ~ 10-12% in the near-term, so if a catalyst does not force the market to reassess the business, the stock will continue going up. I think in the long-run, book value today will prove to have been too high given the risks involved in the liabilities Athene has taken on and the associated economics, but that could take a number of years to play out.

• As mentioned previously, Chinese and Japanese insurance companies have been executing M&A transactions in the U.S. life insurance space. It is certainly possible for someone to make a price-agnostic bid for Athene. However, I don’t view such an acquisition as particularly likely given Apollo’s incentives and voting influence.

Disclaimer: The information contained herein reflects the views of the author as of the date of publication. These views are subject to change without notice at any time subsequent to the date of issue. The author has an economic interest in the price movement of the securities discussed in this presentation, but the author’s economic interest is subject to change without notice. All information provided in this presentation is for informational purposes only and should not be deemed as investment advice or a recommendation to purchase or sell any specific security. While the information presented herein is believed to be reliable, no representation or warranty is made concerning the accuracy of any data presented. In addition, there can be no guarantee that any projection, forecast or opinion in this presentation will be realized.

Catalyst

• Failure to continue rapid rate of growth in heightened competitive environment for both retail business and M&A deals; players competing for large deals in the market include recent private equity entrants (many of which are attempting to replicate Athene’s strategy), Chinese companies like Anbang and China Oceanwide (both seemingly willing to do deals at valuations that are seen as aggressive by the rest of the market), and Japanese life insurance companies (also willing to do deals at aggressive multiples). Additionally, Athene’s former head of corporate development, Steve Cernich, resigned in June 2016. This is noteworthy because Steve Cernich was responsible for architecting many of Athene’s largest M&A deals.

• Potential regulatory scrutiny or action by either the IRS or the relevant insurance regulators; or potential national regulation of insurance companies. Athene is structured very aggressively from both a tax and capital standpoint, by reinsuring most of its business to its Bermuda reinsurer, and by holding most of its statutory capital in Bermuda.

• Issues with restatements of financials or financial controls. Athene is a roll-up in a space with very difficult accounting treatment – historically this has been a bad combination. Additionally, Athene has had 4 different CFO’s in the last four years, indicating the challenging nature of overseeing the finance and accounting functions for such a complex business. Athene previously had to restate its financials due to issues with the Aviva deal; there is reason to believe something similar could happen again when Athene tests its material controls for the first time in connection with filing its 2017 10-K.

• Continued declining operating ROE’s as the economics of business issued in the last year starts to show up in earnings.

• Continued selling of Athene stock by investors in Apollo Alternative Assets as the lock-ups expire over time. The recent spate of exits at the senior management level seems to imply that the primary focus of Athene was on maximizing the IPO valuation, rather than maximizing long-term book value. The recent exits include: Steve Cernich (former head of corporate development, June 2016), Guy Smith (President of Athene USA Corporation, January 2017), and Imran Siddiqui (former board member of Athene, March 2017).