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By Stephen Ellis

This structurally attractive and generally misunderstood industry offers investors opportunities in a fairly valued market.

We believe that the alternative asset management industry is structurally attractive and generally misunderstood by investors. The relative newness of the industry to the public markets, not to mention the complexity of its accounting, has kept many from looking at the group more closely. We also believe that investors do not fully appreciate the business quality or growth prospects for the biggest and best alternative asset managers, which have, in many cases, greatly expanded beyond their initial roots in private equity. The sell side has made some attempts to value the industry using a modified sum-of-the-parts model, but we think that this methodology only adds to the confusion as it deeply undervalues incentive income and relies too heavily on accrued incentive income (which, in our view, is too volatile a metric to be useful). We believe a discounted cash-flow model that relies more on distributable income is a much better way to value the industry. We present a report on the industry that seeks to answer some of the biggest questions that investors might have about the group, including how best to evaluate the industry's competitive advantages.

What Is the Alternative Asset Management Industry?

The publicly traded alternative asset managers are global institutions with decades of experience investing in nontraditional asset classes, primarily by managing money for private and public pension funds, endowments, foundations, and other institutions, as well as for high-net-worth individuals. Most of the industry's largest players - including Blackstone (NYSE:BX), Apollo (NYSE:APO), and Carlyle (NASDAQ:CG) - started off in private equity, but have expanded their reach over time to include credit, real estate, secondary funds, and funds of funds. Other players - like Oaktree (NYSE:OAK) and Ares (NYSE:ARES) - have focused almost exclusively on credit opportunities (distressed, high-yield, convertibles, mezzanine) with great success. The industry has tended to follow the same business model for going public, structuring themselves as partnerships (which file K-1s), with the investment managers themselves listed as the general partners, and investors in their funds designated as limited partners. Investor interest in the products being offered by the alternative asset managers has increased since the 2008-09 financial crisis, with pension funds - many of which have turned to riskier and higher-returning assets during the past 10-15 years in an attempt to close funding gaps - leading the way. In particular, we think that private equity performance has helped increase the level of interest in alternative assets, as returns for the top quartile of private equity funds at 26% and 29% over the past 10 and 20 years, respectively, versus single-digit returns for the MSCI World Index over the same time frame, have contributed to a substantial increase in the AUM for the industry overall during the past 20 years. Given the level of interest that still exists for alternatives, we expect continued healthy levels of growth in AUM for the industry overall going forward.

The most recognizable fund structure used by the alternative asset managers is a closed-end fund model, which would describe the traditional private equity fund model, which typically lasts 10-11 years. In most cases, a general partner will identify a promising investment niche, and engage in a 12-24-month fundraising period when potential limited partners (typically restricted to professional and wealthy investors) can subscribe to the fund. The fund can be considered a blind pool, as limited partners do not have any idea of the potential investments the fund could make, relying solely on the manager's track record and reputation when making their decision to invest in the fund. Once a limited partner has committed capital to a fund, it is required to contribute this capital on demand. The manager of the fund will then invest the capital over three to five years. The latter stages of a fund's life are when the manager sells off the company to a strategic acquirer or another private equity firm, or takes it public and earns incentive fees. Limited partners typically recycle their realized gains into the latest fund being offered by the manager, provided that the performance of the previous fund was satisfactory, making the timing and the size of any distributions to limited partners a critical consideration for the alternative asset manager.

Value creation within private equity typically comes from three sources: leverage, multiple expansion, and operational improvements. In the 1980s, the amount of equity that a private equity firm's general partners put into a transaction was typically less than 10% of the deal's value, with the rest of the acquisition price being funded by debt. The leverage, combined with modest operational changes, typically generated substantial returns. In the 1990s, as banks and limited partners grew more reluctant to fund highly leveraged deals after a series of failures, the equity contributions of the general partners increased to the 20%-40% range, reducing the amount of leverage-fueled gains that could be produced. In terms of multiple expansions, the private equity industry has typically seen the best returns when it has been able to put capital to work in a difficult environment (such as following the 2008-09 financial crisis). Blackstone, in particular, had great success buying highly cyclical companies during the trough, using leverage to multiply the gains on their investments as the industries and general economy recovered. By the late 2000s, the private equity industry had generally turned to operational improvements to drive intrinsic value creation at its investments. Carlyle, Blackstone, Apollo, and KKR (NYSE:KKR), among others, have built out substantial employee bases of in-house executives, consultants, and advisors who have decades of industry experience and can successfully revitalize a company through cost-cutting, acquisitions, or other strategic maneuvers, increasing the chance of producing a successful investment.

What About Unitholders' Interests?
In 2007, the industry became publicly traded for the first time, with the initial public offerings of Och-Ziff (NYSE:OZM), Fortress (NYSE:FIG), and Blackstone. KKR listed on the NYSE in 2010, Apollo began to trade on the NYSE in 2011, and Oaktree and Carlyle followed in 2012, with Ares only recently becoming public in early 2014. The main reasons for the pursuit of IPOs were increased liquidity for the partners' large stakes in the firms, and the ability to pursue acquisitions. Now, unitholders entered the equation. Unitholders neither have a direct ownership stake in any of the funds in which the general partners invest, nor do they directly benefit from the returns that they generate. However, unitholders do retain partial ownership of the income generated through management and incentive fees through their ownership of the general partner. Unitholders are essentially receiving a piece of the management fees and carried interest that is taken in by these firms, after operating expenses (and the capital that management expects to reinvest back into the business) are deducted. However, insiders typically retain the majority of units held, as well as the majority of voting rights through different unit classes. The industry typically pays out the vast majority (80%-90%) of its distributable (cash) earnings as distributions to unitholders.

Despite the lack of control over the firms (and the loss of other related rights that typically accrue to unitholders), we still think unitholders are given a fair deal by the partnerships. Unitholders have placed tremendous pressure on the partnerships to diversify their revenue streams away from the volatile and more market-dependent private equity business, as they've emphasized the value they place on a steady stream of management fees earned from a diverse asset manager. In response, the industry has engaged in a fairly aggressive acquisition spree to expand the scope of the offerings to well beyond their traditional roots in private equity and credit to include real estate, fund of fund offerings, and secondaries, among other offerings. In general, we think this is a positive move as it increases the stickiness of a partnership AUM (which we view as moat-enhancing), especially when a limited partner takes part in multiple strategies. This allows ROICs to be earned through an increasingly diverse business mix rather than on the strength of a given firm's particular franchise, insulating it from the potential for strategies to become commoditized, as many hedge fund strategies have, in our view.

We think there are a few other factors that align unitholder, limited partner, and general partner interests. Many general partners take very limited or no compensation (Howard Marks of Oaktree takes no pay) other than the distributions they receive, thanks to their unit ownership. Their ownership aligns their interests with unitholders in terms of growing distributions over time. In 2008-09, the industry's leaders saw a substantial decline in the overall value of their units as well as sharply lower distributions alongside common unitholders. In addition, though the general partners in most firms typically contribute 1%-2% of a manager's capital to a fund, insiders have been known to contribute as much as 2%-3% (leading to situations like Apollo's $18.4 billion Fund VIII, where insiders and the general partner committed roughly $900 million). This leaves a substantial part of insiders' compensation tied to fund level returns, being locked up alongside the limited partners. Finally, senior managing directors and other key individuals are typically locked up under noncompete arrangements, which prohibit working for a competitor or soliciting clients for a year at minimum. Overall, we believe interests are generally aligned among unitholders, general partners, and limited partners.

How Do Alternative Asset Managers Make Money?
The publicly traded alternative asset managers generate revenue in three different ways: management fees, incentive fees, and investment income, which are then shared with employees and unitholders.

Management fees range between 0.3% and 2.0%, and are commonly charged on committed capital, invested capital, or net asset value. Fees can vary greatly depending on the size of the fund, the current fund-raising environment, the targeted investment opportunity, or the level of capital commitment made by the limited partner, among other items. Typically, we'd expect to see higher fees charged during the investment period for a fund, with rates stepping to a lower level as the fund enters the realization portion of its useful life when incentive income can be generated. Management fees are charged for the full life of the fund, which is usually 10-11 years. Lower fees are sometimes charged for strategies where the expected return is lower.

Incentive fees or carried interest. Hedge fund structures typically earn 20% of the fund's capital appreciation per year, subject to a high-water mark in the 5%-8% range. Carried interest applies to carry funds (such as private equity), where the range of incentive fees can vary depending on the strategy, but are typically between 10% and 30% of any realized profits on an investment, subject to a high-water mark in the 7%-10% range. If a fund does not achieve its preferred return over the life of the fund, managers are obligated to repay the amount in excess of the agreed-on split to the limited partners. This is known as a clawback obligation.

Investment income. To align their interests with the limited partners, the general partners typically contribute company capital, as well as their own capital, to a fund. The range varies depending on the size of the fund and manager, but is usually about 1%-5% of a fund's AUM. These investments are typically held on the company's balance sheet.

Transaction, monitoring, and other advisory fees can also be charged on portfolio holdings, but thanks to limited-partner pressure over the past few years, 50%-100% of these fees (at least for the major players) are generally rebated to limited partners through a reduction in their management fees.

How Do We Determine Alternative Asset Manager Moats?
Traditional asset managers such as BlackRock (NYSE:BLK) have earned economic moats, thanks to high levels of switching costs and strong intangible assets. Once AUM flows into the traditional managers, it tends to stay there, as annual redemption rates of around 30% demonstrate. The traditional asset managers can build on that switching-cost advantage by offering a diverse product mix, having greater geographic reach, being strong in multiple distribution channels, and having a reputation as a world-class investment manager. A niche focus on retirement accounts and tax-managed strategies creates even higher switching-cost advantages for the traditional asset managers. We also believe that a singular corporate culture dedicated to a common purpose, as well as a deep and wide product set across multiple asset classes, allows asset managers to hold on to assets even longer - making these some of the key differentiators between wide and narrow moats in the industry.

Alternative asset managers, in our view, have attributes that can make these moat sources - switching costs and intangible assets - even more indelible. We'd also note that from a financial perspective, putting 1%-2% of their capital at risk within a fund in exchange for 20% of the profits and an ongoing management fee in the 1%-2% range is an extraordinarily lucrative deal for the alternative asset managers. Our moat framework for the alternative asset managers focuses on several key factors:

(1) Fund lives. Unlike the products of most traditional asset managers, which have to rely on investor inaction to keep annual redemption rates low, the products offered by the alternative asset managers can have lockup periods, which prevent investors from redeeming part or all of their investment. Generally, we favor longer lockup periods for limited-partner capital because of the substantial switching costs. A long lockup period, such as the 10-11-year time frame for private equity funds, implies a great level of trust between the limited and general partner, as the limited partner cannot redeem its capital for years. In contrast, hedge fund redemptions can occur as frequently as quarterly.

(2) Operational expertise. Large general partners such as KKR and Blackstone have increasingly provided operational and strategic expertise to their portfolio companies to create value. For example, we estimate that Blackstone employs over 70 professionals (including ex-CEOs), and KKR has nearly 100 advisors and consultants who advise portfolio companies on strategic and operational insights. Duplicating these units would not only be expensive from a compensation perspective, but also would require a sizable and active private equity operation.

(3) Fund-raising expertise. While we believe that the top executives at alternative asset managers play a critical role in raising new funds because of strong and established relationships with limited partners, the largest alternative asset managers have substantial fund-raising organizations at their disposal. Carlyle, for example, has about 80 professionals that segment the markets by region, by product line, and by distribution platform.

(4) Human capital. Firms with a larger number of investment professionals operating across a broader range of asset classes will generally have more extensive and deeper relationships with buyers and sellers, which will generate higher-quality investment opportunities. We also believe a higher number of investment professionals can drive a substantial increase in the number of limited-partner relationships an alternative asset manager develops over time, lowering the implicit cost of acquiring incremental AUM. We think of this element as the "deal funnel," as it focuses on the size and scope of the human capital an asset manager retains. In short, the greater number of investment professionals in-house, the more opportunities the manager will have to land lucrative deals.

(5) Product portfolio. Limited partners are increasingly looking to consolidate their assets with fewer managers that operate across a wider range of asset classes and strategies in an attempt to reduce oversight costs. Managers that can develop and source deal flow (and thus investment opportunities) across a wider range of strategies and asset classes are more likely to inbound incremental capital.

(6) Reputation. Managers that have a long and successful track record of strong investment performance (preferably over decades), and also have a history of treating limited partners with respect, are better positioned, in our view, to attract incremental capital than a startup with a much more limited track record.

(7) Culture. We think that alternative asset managers that operate across a broad set of investment strategies and product offerings, and that incentivize these different teams to work together (either by compensation/incentives or through a common culture of sharing ideas) have an additional competitive edge. We believe Carlyle, Blackstone, and KKR have some of the strongest internal cultures and are actively working together to put more money behind their best ideas through idea sharing. For example, Blackstone put more than $10 billion to work across the firm supporting its improving housing thesis, which was based on insights gleaned from its private equity, credit, real estate, and solutions segments, and resulted in investments in single-family homes, home automation services, credit financing, nonperforming residential loans, mortgage servicing rights, and the purchase of homebuilder and related equities.

(8) Geographic reach. The larger an alternative asset manager's base of global offices, investments, and overseas clients is, the further along it will be in developing relationships with the limited partners of tomorrow (which are increasingly sovereign wealth funds), as well as sourcing international deal flow. Carlyle is by far the leader here, with about 25% of its investments being made outside of North America and Europe the past few years, versus 15% at its major peers. Carlyle also has the largest amount of region-specific funds, and investors are increasingly looking for emerging-market funds.

Our Alternative Asset Manager Moat Framework Heat Map
(click to enlarge)
Source: Morningstar

How Do We Determine Moats for Each Manager?
Though all of the publicly traded alternative asset managers broadly operate under the same business model of collecting and retaining fee-earning AUM and making successful investments, we think there are several key elements that differentiate each of these managers that investors should understand. We tend to award the industry narrow moats because of the explicit switching costs associated with the long lives of carry funds, which are 10-11 years. We also award narrow moats based on the strong reputations and the scale needed to invest in the back-office systems required to meet increasingly tougher regulatory and limited-partner transparency and reporting requirements.

It also helps to look at the level of total AUM each of the alternative asset managers is managing, as well as the diversification that exists in their asset bases (specific AUM amounts mentioned in this piece are as of March 31, 2014). Of the eight publicly traded alternative asset managers, Blackstone at $271 billion has the largest level of AUM dedicated to alternative assets and owns the only sizable real estate division, with Carlyle at $199 billion being a close second. Apollo stands out next with $158 billion in mostly credit AUM, while KKR, Oaktree, and Ares follow up with $102 billion, $86 billion, and $77 billion in AUM, respectively. Och-Ziff and Fortress are the two smallest players in the group at $42.6 billion and $36 billion (excluding its traditional fixed income AUM), respectively.

Blackstone is also the most diverse of the alternative asset managers. It garners 30% of its AUM from real estate, 24% from private equity, 24% from credit, and 21% from solutions, where the firm directly allocates investor capital to hedge funds, but offers options to others. Only Carlyle comes close to the same level of diversification as Blackstone, with 50% of its AUM devoted to private equity carry funds, 29% to solutions, where it primarily allocates investor capital to private equity funds, and 12% and 6% in credit and real estate, respectively. KKR is mostly split between private equity and credit, and Ares and Apollo are focused nearly entirely on credit AUM. Finally, Och-Ziff and Fortress are primarily weighted toward hedge funds and credit, with Fortress retaining a sizable but declining private equity franchise.

From a fund-raising perspective, there are also differences in the quality of alternative asset managers. Scale is increasingly becoming more important in fundraising. We believe dedicated teams and global offices are needed because the number of marketing channels is fragmenting across the industry. Inflows from pension funds and funds of funds are increasingly stagnating, while sovereign wealth funds and retail investor channels are growing in importance, demanding higher levels of marketing investment than in the recent past. At more than $150 billion in funds raised from 2011-13, Blackstone has raised more investor capital than its next four largest peers combined. The firm has accomplished this remarkable feat primarily through introducing new and innovative strategies that meet limited-partner needs. For example, its Tactical Opportunities effort, which seeks to invest in opportunities that might not fit within its traditional private equity, credit, or real estate niches, and the fund quickly raised $5.6 billion, and the partnership is pursuing fundraising for a second fund this year.

Carlyle has also been very successful, pulling in over $50 billion in the past few years, thanks to its broad and deep fund portfolio, which includes many region-specific funds, letting investors target specific strategies and geographies that meet their allocation requirements. Meanwhile, Oaktree and Ares have done well raising money for their credit funds, and at $33 billion and $27.5 billion ($34 billion including real estate and private equity for Ares), respectively, their inflows compare favorably against Blackstone's $55 billion in credit inflows, and are stronger than their next-closest peer, Apollo, at $12 billion in credit fundraising. KKR and Apollo delivered $36 billion and $33 billion in AUM inflows, respectively, mostly weighted toward private equity. We think both partnerships can do more here to leverage their existing relationships with limited partners to bring in more AUM, and as both asset managers have been highly aggressive in acquiring new strategies and AUM, we think they will be able to leverage the newly expanded product portfolios and relationships to boost fundraising efforts going forward.

There are also substantial variations between asset managers in terms of the strength of their product offerings and geographic reach, and the depth of their human capital. Blackstone and Carlyle own some of the deepest product portfolios, which allow limited partners to invest in multiple funds and strategies, at a variety of price points, with varying levels of transparency, size, and time commitments. We also think the pair benefits from a substantially greater number of investment professionals and wider global reach (as measured by number of offices worldwide), where the relationships in place ensure access to the highest-quality investment opportunities and ensure that they are first in mind for any limited partner looking to increase its alternatives allocations. KKR also stands out from its peers, as it is rapidly expanding its product portfolio and adding investment talent, and we think it will be able to convince more clients to sign up for multiple strategies going forward. Apollo, Ares, and Oaktree have largely remained within their traditional niches within private equity and credit, and have pursued only modest step-out strategies in recent years. Finally, Och-Ziff and Fortress have very limited product portfolios, geographic reach, and a small cadre of investment professionals, which we believe limit their ability to raise funds, develop new strategies, and inbound attractive investments.

Source: Finding Value In Alternative Asset Managers