Introduction: A steadily growing industry swimming in capital
The private equity, PE, model of asset management, or "alternative" asset management in this expanding industry's own lingo, now controls more businesses, employees, real estate, infrastructure and credit than ever before. And this is not set to change soon as the PE industry sits on record uninvested capital commitments, so called "dry powder."
A number of major PE players have chosen to publicly float their partnerships units on U.S. markets during the last decade. The universe scanned for this article includes the largest U.S. PE groups in the top 100 of the 2016 PEI300 universe, which is based on private equity capital raised (LP commitments, will be discussed later) during the most recent five-year trailing period, plus a few major listed partnerships more focused on the private debt/credit, private real estate and private infrastructure segments. Making a quick selection within this universe, the following U.S. entrants will be studied:
- 2007 IPO: Blackstone (NYSE:BX) + Fortress (NYSE:FIG)
- 2009-2010 IPO: KKR (NYSE:KKR)
- 2011 IPO: Apollo Global (NYSE:APO)
- 2012 IPO: Carlyle (NASDAQ:CG) + Oaktree Capital (NYSE:OAK)
- 2014 IPO: Ares Management (NYSE:ARES)
Interestingly, despite entering the U.S. stock market at different points in the market cycle, not a single one of these PE partnerships has matched the total returns of S&P 500 since IPO, in many cases due to giving up previous outperformance in the most recent 12 months.
At the same time, top insiders at major PE firms consider their common units to be undervalued in the stock market. While skewed incentives make such claims hard to be taken seriously in general, there could be some merits in arguments along the line that the stock market is having difficulties in understanding these relatively new public market vehicles.
This article will first briefly explain how the PE fund management business has its own set of economics quite different from those of traditional fund managers, such as BlackRock (NYSE:BLK) or State Street (STT), or from investment banking/trading groups such as Goldman Sachs (NYSE:GS) or Morgan Stanley (NYSE:MS).
I will then outline a simple framework for evaluating the implied business value of listed PE units, i.e. how the market's expectations on different PE partnerships' future prospects differ.
The PE business model: Make them commit and get paid to deliver
Like for most asset management businesses the goal of private equity funds is to make as much money for their investors as possible, given some set risk constraints and other investment mandate factors.
In the PE fund model a general partner, GP, sets up a fund structure with the aim to invest in some sort of illiquid assets, typically in an unlisted, private setting. The GP being a specialist in this specific investment strategy then goes out to the PE partnership's network of investors to try to market and raise capital for the fund. The listed partnership units discussed in this article are GP units.
The outside investor who gets to invest with the GP becomes a limited partner, LP, in the specific fund. The LP agrees to commit some amount of capital for the fund, typically for a multi-year period. The GP will later make future calls for this capital when it has found interesting enough investment opportunities for the fund. The goal for the GP in any given situation is to maximize the internal rate of return, or IRR, that the LP's capital is compounded at. When an investment is partially or completely exited, the GP returns capital to its LPs, after fees.
The PE fund management business provides the GP with the following major revenue streams:
- Management fees: The PE business involves charging LPs percentage fees on invested (but unrealized) capital, typically 1-2 % annually.
- Carried interest: The GP is also entitled to profit-sharing on the LP investments when investments are exited at above some specific minimum realized return threshold. The structure can be that a 20% profit share goes to the GP if the realized return has exceeded 6-8 %, but the levels vary based on asset class among other things.
- Other fees: Many PE GPs charge various other forms of fees at the portfolio holding level. Many of these practices are considered more controversial and have been publicly criticized and investigated in recent years. In addition, major PE firms are expanding their own capital markets desks, generating underwriting and syndication fees when handling public market transactions in equity or credit.
In its 2015 global PE investor survey, the consultancy firm EY (and Private Equity International) found that only 22 percent of PE LPs claimed to pay a full "2 and 20" fee structure, meaning a 2 percent management fee and 20 percent carried interest. 42 percent of the respondents paid less than "2 and 20" and 36 percent answered that they paid a "customized" fee structure.
Of the above income streams the management fees are easy to understand in that they are similar to the fees of other wealth management businesses, including public equity fund managers. Though substantial it is not the fixed management fees that makes PE an attractive business however, it is the often misunderstood carried interest.
Carried interest is powerful in that it provides a clear alignment of interests for the GP management: maximize your LPs long-term returns in order to get to share the profit windfall at exit. With carried interest the founding partners of successful partnerships may over time become billionaires without having to put up significant investment capital to begin with (a side note: in the world of many PE directors one's time and work efforts are considered some sort of intellectual capital invested where carried interest is the resulting capital income, at least when it comes to the subject of minimizing personal income taxes).
If we consider the average investment holding to cover its associated direct operating and financing expenses, the fund management side of the PE business involve:
- Lots of compensation: The GP employees and directors may earn competitive salaries and perks plus a very significant share of the carried interest charges. For the latter arrangement to be optimal and sustainable, it should of course be executed so that it is well-aligned with the interests of the LP investors and minority unitholders in the listed partnership. Part of compensation comes in the form of partnership units and the resulting dilution is something minority holders of the common units must take into account.
- Advisory fees: Given their transaction-focused activities, PE partnerships will over time have to pay huge fees to external investment banking, legal and tax advisors when they want to buy/sell investment stakes, avoid/win litigation and minimize taxes paid by holdings and/or the partnership itself.
- Litigation: Being highly active in distressed market situations means that PE partnerships are at more or less constant risk of getting substantial litigation claims from dissatisfied LP fund investors, trade unions, regulators and tax authorities, whether the single case is motivated or not. Some cases can be settled at the fund level but in other cases it will be the GP partnership's capital that covers damages or settlements.
From an economics perspective the PE model offers GPs the opportunity of managing portfolios of long-term options, where each LP commitment represents a more or less complex call option with certain duration and strike price related to the future performance of some specific investment strategy. This enormous leverage offered by the PE model represents value to the partnership, if managed sensibly by the GP.
Being a minority unitholder in listed PE partnerships
As a unitholder in a publicly traded PE management partnership you are really a minority owner in the GP in an economic sense. Given that the GP management is successful in raising and structuring LP capital and then delivers satisfactory returns to these LPs, there will over time be value to be shared between 1) compensating the GP employees and directors (including carried interest, unit dilution) and 2) passive minority holders of the common units. Capital transfers to the partnerships' common unitholders are generally in the form of cash distributions or through unit buybacks.
So given that the GP organization does not mess up its investment performance or get overly greedy on compensation, public common unitholders get to share the upside while not having the legal responsibilities of the GP. The one single responsibility you will have is paying your share of taxes, a vast topic I will leave for contributors with intricate knowledge of U.S. tax code to discuss.
Cyclical investing pattern and industry returns up for debate
The investing behaviour for the PE industry as a whole is highly cyclical, with LPs willing to commit more capital well into bull market runs, which historically have resulted in a fund commitment pattern where the PE industry receives too much capital very close to peaks in the market cycle, when asset risk premiums in general are the thinnest. (The record dry powder of the PE industry and quite lofty private and public deal multiples could suggest that we are in this phase right now.)
Study the following Prequin chart and you get the point: capital committed peaked around the bursting of the Dot Com bubble and in connection to the Global Financial Crisis (the 2015 numbers in the chart are preliminary so that is not a sharp drop in terms of capital raised, although the number of funds closed fell):
This cyclicality is also present in after-fee returns, where LP returns are intuitively higher when capital is committed and deployed in times of illiquid markets with asset prices under pressure. Thus funds with "vintage years" before the Great Financial Crisis ended up overpaying for assets while those who launched right after the crisis could go on a bargain hunt and generate great returns. So this industry is characterized by return variability over the market cycle:
When it comes to return levels economics researchers such as Harris, Jenkinson and Kaplan have pointed out that for post year-2005 vintage funds the average PE fund in the company buyout segment has not been able to outperform the S&P 500 (NYSEARCA:SPY). That could point to either harsh competition for economic profits or to excessive non-performance related fees, but most likely both.
Noticeable in the graph above is also the great after-fee return variability between funds. Here the growth of some of the listed managers to enormous assets under management, AUM, do indicate that LP investors feel more confident on these GPs' abilities to deliver outperformance going forward, right or wrong. However, researchers are skeptical on whether individual PE managers' return performance has continued to be "sticky", i.e. whether successor funds of currently outperforming managers are more likely to outperform, a correlation that was once upon a time when the industry was younger and much smaller.
Assets under management mix more interesting than size?
Now, let's look at some partnership data. Below are the relative sizes of our U.S.-listed PE partnerships' AUM: Here Blackstone, with more than 350 billion USD in AUM Total, currently dwarfs the other industry players. Its AUM is twice the size of that at the second and third largest partnerships, Carlyle and Apollo Global. The smallest partnership included is Fortress, at around a fifth of Blackstone's AUM size.
Size in absolute terms is seldom that interesting though, it is more often relative metrics of a business that will decide its fate. We can start by studying the approximate composition of the partnerships' AUM below:
Here, note that KKR gives its unitholders the most focused AUM exposure to traditional company buyouts, the Private Equity segment.
At the other end of the spectrum Apollo, Oaktree and Ares are more of credit shops, dealing in distressed debt, direct lending and various other credit strategies.
The industry giant Blackstone is essentially spreading out its AUM evenly in the four main asset segments and Fortress is different from the rest of the group in its tilt towards hedge funds.
Valuation: Cutting through balance sheet differences
Below you find my valuation summary on these PE partnerships. Starting from the left the current average partnership market capitalization is 10 billion USD, ranging from 33 billion in Blackstone down to 2 billion in Fortress.
The partnerships that have managed to grow their AUM at the fastest pace per unit the most recent trailing twelve months were KKR, +16 percent, and Fortress, +16 percent (mainly due to shrinking unit count). Growth has been positive for Apollo, Ares and Blackstone as well, at +7 to +8 percent. At the same time Carlyle, -9 percent, and to a lesser extent Oaktree, -4 percent, have been shrinking per unit-AUM lately.
Now that we have finally reached valuations I will not go for standard valuation metrics first, which have comparability and relevance issues if presented unadjusted, but rather get straight to the point:
What we want to compare are balance sheet-adjusted market values of the underlying business, in this case how the stock market prices the PE fund management business adjusted for differences in the PE partnerships' balance sheets. This is similar to the enterprise value, EV, concept for an operating business.
I found that the following simple concept setup can use observable data to back out estimates of the stock market's current implicit equity valuation of the PE fund management businesses:
[PE business] =
[Mcap common units]
- [Unrealized carry]
+/- [Net debt(cash)]
Practically I just take the current market capitalization of the common partnership units, then deduct at book value the partnership's own investments and unrealized carry, adjust for partnership debt minus cash and finally add preferreds outstanding and minority owners share (of partnership capital in cases where not all partnerships were included in the market capitalization unit count). The results are presented in the table's middle section below:
In a sector full of optionality, some offer more for less
The implicit valuation metrics show that when adjusted for balance sheet differences the partnerships trade at a mean average of 4 percent of AUM Total. So for around every 25 dollars of AUM Total the market has assigned only 1 dollar of partnership business value.
Given the fee levels discussed and the long commitment periods of much of this AUM, one does not have to be a rocket scientist to understand that these partnerships as a group offer quite substantial upside optionality.
In terms of fee related earnings, or similar non-GAAP measures offered by the partnerships, these underlying PE businesses trade at a median multiple of 19 times. Note that this earnings level excludes transaction profits and carried interest, with its discussed upside optionality, so it is more a measure of size and cost efficiency than of the real income generating potential of the partnership over time.
When one gets down to the partnership level it starts to get really interesting. At one end of valuations, investors willingly pay up for Blackstone's and Oaktree's AUM and management fees, with hefty premiums to peers. Thus a starting point if having no other insights, could be to avoid these units until being convinced or proven that they deserve their premiums.
At the other end of the spectrum, Fortress, the hedge fund-focused smallest player, offers by far the best AUM leverage in the sample, indicating that investors currently have issues with either the quality of hedge fund assets and/or with Fortress's execution of the partnership strategy.
The market is also skeptical in its pricing of Carlyle's AUM, which includes a hedge fund segment under reorganization and substantial investments in the currently pressured energy sector (which are of course a long-term opportunity if one believes in a rebound).
Myself I have so far only invested in KKR's units, which adjusted for balance sheet still trade at the lowest identified management fee multiple of only 7 times, a bit more than a third of the sample median or a bit more than one fourth of Blackstone's level. On AUM, KKR trades close to the sector median (and for a bit of a discount on AUM Dry Powder).
Part, but not all, of the lower implied PE business value of KKR has to do with that it is different to the rest of the partnerships in that uses a much larger portion of its own partnership capital (equity) to invest directly in the partnership's funds and different business ventures. KKR's ratio of own investments (at book value) in relation to AUM Invested is 8 percent, whereas the median partnership keeps its own capital investment at around 1 percent. Based on its relative discount valuation the market does not seem to think that KKR's own principal investing activities are as interesting as just being a PE manager with very little skin in the game (0-2 percent based on this summary's metric).
Ares Management has rebounded very strongly in the last few days, perhaps due to a few bullish interview quotes from fund manager Chuck Royce in Barron's, but still trades at a management fee multiple of 10 times, slightly more than half the sample median. In terms of AUM valuation, Ares units have just been pushed over the sample median.
Standard metrics have clear limitations with PE partnerships
In terms of standard basic valuation metrics, in the right section of the table above, most partnerships' units trade at around 3-3.5 times book value (P/B), not that much higher than U.S. Large Caps in general in the form of S&P 500. The outlier P/Bs are noticeable, but at the same time not great points to make inferences from, given the discussed major differences in balance sheets at the partnership level.
The current distribution yields of the units have a median of 5.2 percent (based on most recent quarter annualized), which is 2.5 times the current S&P 500 dividend yield. Carlyle tops the range with a current yield of 15 percent while Ares offers the lowest current yield of 3.5 percent.
To price PE units on yield like some other types of listed partnerships would intuitively not make very much sense though, since distribution levels over time will be as much a reflection of partnership capital policies, lumpy investment exit profits and tax considerations as an indicator of the underlying cash-flow generation of the PE partnership business.
Key takeaway for investors: do not overemphasize current PE unit yields, focus on the valuation of the PE fund management business instead.
Conclusion: PE units are good hunting grounds for optionality
Private equity managers are perhaps strange animals compared to other financial firms on U.S. stock exchanges and valuing these businesses may seem tricky since the reported financials do not quite reflect the underlying business economics of managing PE funds.
This article's top-down perspective on the major U.S. listed PE universe shows that the partnership units still offer huge optionality, in terms of implicit values of PE businesses relative to assets under management. While waiting for such optionality to play out partnership investors are compensated for the risk with current distribution yields that are generally in the 3 to 7 percent range (pre-tax).
Among the partnerships more focused on traditional company buyouts and/or real assets, the stock market trades the units of industry giant Blackstone at a very significant valuation premium. At the same time KKR, which has been growing assets under management the fastest recently and which has most skin in the game in terms of investing its own capital alongside limited partners, trades at a very significant discount.
In the more credit-focused end of the spectrum the market is willing to pay up significantly more for Oaktree than for Ares Management, or Apollo Global for that matter. And hedge fund-specialists Fortress does at least optically seem to be on sale.
That's the end of the field guide so please feel free to share, comment, discuss and/or follow up if you found it interesting or want to expand on some specific related topic.
But what are PE units really worth? Potential follow-up topic
Now, sound investment decisions in PE partnership units cannot be based on AUM and fee multiples alone. I might follow up this article with shorter pieces discussing what is the fair value of a few of these major PE partnerships, i.e. how much to pay for a specific partnership's units.
That could include analysis of risk-return relationships and whether some partnerships have excess return fundamentals that warrant a franchise value component in their stock market valuation.
Disclosure: I am/we are long KKR.
Additional disclosure: Eklund Research is currently a unitholder in KKR and may increase or exit his position at any time. The same goes for initiating potential long and/or short positions in Apollo Global, Ares Management Blackstone, Carlyle, Fortress and/or Oaktree.