Description

Idea  

Long CG, short BX pair trade.

Catalyst:  Reversal of market over-reaction to CG’s hedge fund implosion at CG-owned Claren Road Asset and Vermillion

NB: Shares outstanding and market cap are on a fully-diluted basis, as if all private, no-float LP interests were publicly traded.

The Blackstone Group L.P. (“BX”) and The Carlyle Group L.P. (“CG”) are two preeminent alternative asset managers. BX and CG are very similar to each other with respect to their businesses, investment orientation, investment returns and professional quality.  From 8/1/13 to 8/1/14, their stock returns were highly correlated.  From 8/1/14 to 8/1/15, BX outperformed CG by approximately 50%.

This relative return differential is an over-reaction to poor investment returns recorded at CG-owned hedge funds.  The relative investment returns of BX and CG should revert back to the mean, with CG outperforming BX in the medium term, as investors “get over” Claren Road and Vermillion.  

Therefore, a pair trade, long CG and short BX, should provide a positive return as this “hedge fund over-reaction” subsides, irrespective of the unhedged performance of either CG or BX.  

Dropbox file copy of this idea:  https://www.dropbox.com/s/aquwqdv9pcidtdn/VIC%20third%20submission.docx?dl=0

Thesis

Introduction

Two-year BX/CG common stock comparison chart (8/1/12- 8/1/14)(BX=blue; CG=black)

Two-year BX/CG common stock comparison chart (8/1/13- 8/1/15)(BX=blue; CG=black)

One-year BX/CG common stock comparison chart (8/1/14- 8/1/15) (BX=blue; CG=black)

In the twelve months ended August 1, 2015, BX common stock appreciated over 22%, while CG common stock depreciated over 28%, resulting in a differential of approximately 50%.  What explains this differential?

CG-owned Claren Road suffered multiple adverse investment results in the fall of 2014, including most prominently a loss on their GSE investment position resulting from Judge Lamberth’s grant of the motion to dismiss the Perry plaintiffs’ complaint.  (I have elsewhere on the VIC site explained my view that this decision was in error, and that an investment in the GSEs will prove meritorious eventually.  However, you don’t have to share this opinion with respect to the ultimate value of an investment in the GSEs in order to consider this pair trade thesis.) Vermillion suffered significant losses (approximately 23% in 2014 and a further 7% in early 2015) in its commodities trading funds.

Claren Road and Vermillion have been a “bad news story” for CG for the last twelve months ended  8/1/15, as Claren Road suffered investor redemptions totaling approximately 50% of its $4B assets under management, and Vermillion separated from CG after Vermillion suffered redemptions totaling approximately 37% of its $2B assets under management.

In my view, this pair trade is worth considering even when you completely write-off CG’s economic value in Claren Road and Vermillion, as I believe that the principal reason for this recent relative outperformance by BX over CG has been an excessive negative reaction to CG because of Claren Road and Vermillion.

In the twelve months ended 8/1/15, CG lost over $1.9 billion in total equity value.  CG carried its economic value represented by Claren Assets at $255 million at 6/30/15.  CG recently announced that it would take a charge of between $100-175 million relating to Claren Road in this quarter.  I have found no similar disclosure relating to Vermillion, but I believe the impairment loss is smaller at Vermillion than Claren Road.

To give you a sense of the market over-reaction to CG’s hedge fund performance that has (in my view) been the principal reason for the $1.9B decline in CG total equity value, Distributable Earnings from CG’s “Investment Solutions” segment (which includes CG’s hedge funds) was $29 million in the twelve months ended 6/30/15, a 45% decline the twelve months period ended 6/30/14.

During August 2015, BX has continued to outperform CG, with a -15% return for BX and a -22% return for CG.

CG/BX Comparison

If my thesis is correct, then there is sufficient comparability between BX and CG businesses and investment results to suggest that the return differential over the past year in favor of BX is over-done, based on an over-reaction to the hedge fund situation at CG, and that the BX/CG comparative return results will revert as the CG hedge fund situation fades away from market perception.  

Set forth below is the summary of my BX/CG comparability analysis.  Before I continue, I want to emphasize that BX and CG are complex organizations (indeed, actually a pain in the ass to research in depth), both in terms of their investment assets under management and organizational structure. One can get lost in the analytic/metric weeds quickly.  I have tried to confine my comparability analysis to metrics that seem to make the most sense to me, as someone who is looking at their recent returns more to understand whether the recent BX/CG valuation divergence makes sense than from long time analytical study.  

I have compared CG and BX based upon their total equity values at the holding company level, since the publicly reported equity values do not promote comparability, since 21.5% of CG Holdings total equity is publicly traded, while 51% of BX Holdings total equity is publicly traded.

Moreover, I find that there is an air of unreality to the typical analysis of alternative asset manager valuations.  Much analysis is based upon “Economic Net Income” (ENI), which isn’t net income at all, since it includes unrealized gains based upon Level III analysis conducted by management. (Level III inputs to the valuation methodology are unobservable and significant to overall fair value measurement. The inputs into the determination of fair value require significant management judgment or estimation).  In short, while there is financial value represented by ENI (as there is with proved undeveloped reserves), quantification of that value is quite uncertain and subject to revision before realized.

Even with Distributable Earnings (DE), which is closer to an actual cash flow amount, the recognition of even realized gains is very much at the discretion of management since exit transactions are, at least to a certain extent, subject to management timing preferences. Because of this, short-term variations in valuation in CG and BX may diverge from longer-term trends.

I invite VIC members who have followed alternative asset managers, in general, and BX and CG in particular, to review this idea with the purpose of supplementing  and critiquing my analysis, and challenging me in the message section where you think appropriate.

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*Since less than 100% of the limited partner interests of BX and CG are publicly traded, I have grossed up reported total book values of the private (non-float) limited partner interests to an implied total limited partner interests value based upon the respective public unit prices.  CG had 318,224,337 total Carlyle Holdings units outstanding on 12/31/14, and BX Holdings had 1,158,741,134 units outstanding on 12/31/14.

**The purpose of this percentage data is to show the relative contribution to CG and BX from the PE, RE and HF segments.  CG reports segment DE, while BX reports only segment ENI.

So what have we learned for this chart?  In terms relevant to my thesis, we have learned that the hedge fund segment is relatively unimportant to both CG and BX, and that while CG is far more concentrated in PE, CG’s concentration in the combined PE and RE segments is not too different from BX’s PE and RE combined segments.

Going forward, CG and BX valuations should be driven by non hedge fund segment returns. This serves to highlight the degree to which the market’s punishment of CG for poor hedge fund returns over the past twelve months represents an over-reaction that should reverse over the medium term.

Catalyst

Reversal of market over-reaction to CG’s hedge fund implosion at CG-owned Claren Road Asset and Vermillio