Description

I calculate that Carlyle will generate ~$2/share of through-cycle earnings per share.  It trades today at $16, with $4 per share in net cash & investments & accrued carry, so you get to buy it at 6x earnings ex-cash. 

The $2 is a pretty conservative number – it assumes that only the PE business generates carry (so zero assumed from HFs, credit, and real estate) and PE generates returns through-cycle at a gross, pre-fee 15% IRR. 

Is 6x mid-cycle earnings cheap for a very cyclical, volatile asset?  Yes, I think it is.  The stock is indeed volatile but the business is not as cyclical as you might think – owning a platform that a) owns assets and b) will buy more in the future, possibly benefiting from lower prices, is not the same as directly owning assets.  And I think that PE-centric alternative asset managers are actually quite good businesses with secular growth.

Alternative asset managers have been written up multiple times on VIC so this is certainly not a new thesis.  My goals with this writeup are:

1)      Explain to you why Carlyle is unusually cheap and attractive, even vs. other alternative asset managers and vs. previous points in time.

2)      Try to persuade non-believers in the AAM thesis by framing the key issues in a slightly different way.

Carlyle Background:

·         Carlyle has $176 bn AUM, split into $58 bn PE, $35 bn “Global Market Solutions” (HFs and Credit), $38 bn “Real Assets” (real estate and energy), and $46 bn “Investment Solutions” (secondary PE; a low-fee business).

·         Let’s focus only on the PE business ($58 bn AUM out of the $176 bn reported by Carlyle).  This alone is enough to drive a great thesis at these prices. 

·         Carlyle corporate PE’s track record: 26% gross, 19% net since inception in 1987 on total investments (see the table at the back of their quarterly press release). 

o   CP Fund IV, launched 12/2004: 16% gross, 13% net

o   CP Fund V, launched 5/2007: 18% gross, 13% net

Thesis:

·         Secular theme: Alternative asset management is still taking share from traditional asset management.  This is part of what separates the AAMs from the “cheap stock but deserving of low multiple” criticism.  This is a real tailwind of through-cycle growth.  Even if it never gets the multiple it deserves (which could very well happen), it is worth holding for the longer-term compounding.

·         Alternative asset managers are actually quite good companies.  They are extremely capital light (and the proprietary investments they do deploy get a return rather than sitting there like inventory), “people light” (leading to high margins), and very scalable.  Despite enormous competition with other asset managers, fees are not based on return-on-capital metrics for the GP, and can thus offer very high ROICs even if you assume significant further fee compression.

·         Carlyle is at a very cheap multiple of normalized, through-cycle earnings.  I calculate it trades at 8x normalized earnings – or a 12.5% yield.  Add that to ~5% through-cycle annual AUM growth and you get a very good return – whether through holding through the hold period or getting that return pulled forward if valuations rise sooner.

o   A way to back-of-the-envelope this: Carlyle trades for only $3.8 bn EV, a ridiculous number for such a high quality franchise, near the lowest of the main group of PE-centric alternative asset managers.

§  (Calculation: EV = Market Cap – Proprietary Investments + Holdings-level Debt)

§  BX: $24 bn EV

§  APO: $6 bn EV

§  KKR: $5 bn EV

Variant perception:

·         Difficult to ascertain true normalized earnings.  Yes, earnings are high and the stock is optically cheap, but aren’t we at a peak of the cycle? 

o   We can get to normalized earnings by modeling performance fees with a through-cycle IRR.

·         Time arbitrage: Carry gets a low multiple in the market.  The crazy volatility in the share prices make alternative asset managers hard to own.

o   Even if the stock stays cheap, the earnings and dividends generated will add up.

·         Annoying to own because it is a partnership (pass-through), not a corporation.  To avoid passing on K-1s to your investors, you may need to hold it on swap, which has negative tax consequences for onshore investors (carry income delivered via swap would be taxed at the ordinary income rate instead of the long-term capital gains rate).

·         Headline noise about difficulties in its hedge fund business.

o   The headline noise around Carlyle’s bad performance (Claren Road, Vermillion) was outside the key PE business.  The PE business is doing fine.

Key risks:

·         High beta, trades very cyclically.  Heads up for high volatility.  Though the current cheap price may partially mitigate this.

·         Carried interest taxation. 

o   This would make this investment’s returns worse, but not thesis-endingly so.  You can have a great return even with carried interest taxed at ordinary income rates.

Disclaimer: This memorandum is for discussion purposes only and is not intended to be, nor should it be construed or used as, financial, legal, tax or investment advice or a general solicitation.  This memorandum is as of the date posted, is not complete and is subject to change. The data contained herein are prepared by the author from publicly available sources and the author's independent research and estimates. Certain information has been provided by sources believed to be reliable, but has not been independently verified and its accuracy or completeness cannot be guaranteed and should not be relied upon as such.

Catalyst

Unfortunately, this is catalyst-lite.  The multiple may stay low for a long time (although the current multiple is unusually low vs. peers and historical valuations).

·         Eventually:

o   High dividend payout as investments are realized.  Carlyle has already paid out $8 per share in dividends since its IPO in 2012.