Why I Sold Apollo Investment Corp., Part ll

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As described in Apollo's (NASDAQ:AINV) registration statement filed April 15, 2011, Apollo's investment adviser is paid a fee in two parts: a base management fee of 2% of assets, and an incentive fee based on the extent to which short-term (quarterly) returns exceed 7% annually (1.75% in a quarter). The incentive fee can reach "20% of ... pre-incentive fee net investment income for the quarter." Based on these fees and other listed expenses, Apollo illustrates prospective investors' "total annual expenses" at 4.50% of total assets (p.36), which might seem shockingly high if Apollo didn't disclose expenses of 7.94% when measured as a percentage of net assets attributable to common stock.

Ever paid 8% in fees and expenses to own a bond fund?

Apollo is predominantly a leveraged bond fund. Its investments are overwhelmingly debt rather than equity, and it multiplies returns by using not only investors' equity but the company's own borrowings. Apollo is regulated as a Business Development Company, which limits its permitted leverage to a limit much lower than permitted to banks). Apollo avoids corporate-level taxes by virtue of its qualification as a Registered Investment Company, which enables it to avoid taxation on distributed taxable income so long as it distributes at least 90% of its taxable income as dividends. These characteristics are not unique, and as we've seen in the previous installment, Apollo has not demonstrated unique performance.

One wonders why one would prefer to invest in Apollo rather than in a leveraged bond fund that pays less expense while also avoiding corporate-level taxation on the basis of special tax qualification, and building shareholder value. Neither of American Capital Ltd.'s (NASDAQ:ACAS) publicly traded funds offer the summary table Apollo publishes in its registration statement, but annual data from 2011 can help us figure a comparison. At American Capital Agency (NASDAQ:AGNC), annual expenses in 2011 were nearly $74m on an average stockholder's equity just south of $4.2B, for an expense rate of nearly 1.8% of shareholders' assets. At American Capital Mortgage Investment (NASDAQ:MTGE), the partial-year results for its IPO year included expenses of 0.43% of assets, equal to 3.42% of stockholders' equity. Apparently the economy of scale can really move the needle in these funds. Neither of the companies managed by American Capital has, however, been obliged to spend near the 8% rate suggested by Apollo in its shelf registration. The difference in fees is a nontrivial factor looking for a financially effective fund, and becomes especially worth considering when one considers that Apollo is willing at its projected expense level to dilute investors' interest by selling equity below book, while our alternatives are led by a manager with a strong history of issuing equity at prices accretive to NAV in managed funds.

American Capital Mortgage Investment Corp. is so much smaller than its older sister American Capital Agency Corp. that above-NAV equity issuance has a proportionally higher impact on existing shareholders. This doesn't mean that American Capital Agency can't raise capital to the benefit of shareholders - it raised over a billion bucks at accretive prices in 4Q2011, but the ease of moving NAV is greater with a smaller initial company. American Capital Mortgage went public last year at $20, selling 10m shares that each now enjoy a last-published NAV of $20.87. After I predicted American Capital Mortgage Investment's manager American Capital Ltd. would issue American Capital Mortgage Investment shares above NAV to grow its own shares' value while enhancing its management fees, American Capital Mortgage Investment promptly humored the author by filing a new shelf registration suggesting an intent to double its shares outstanding by issuing another 10m shares with a target price of $21.70.

As noticed by Tim Beyers back in October, however, Apollo's management has asked for authority to issue equity at prices below NAV - and not just during some particular crisis, but four years in a row. As Mr. Beyers described, Apollo's management takes little effort to explain why shareholders should approve below-NAV issuance, instead trotting out "explanations" that invoke not the specifics of attractive deals, but macro factors that are conveniently beyond the power of management to control. Apollo's latest shelf registration filing proposes the sale of another billion and a half dollars of Apollo securities (not necessarily limited to equity, but potentially to include other dilutive securities such as warrants or convertible bonds), with no assurance that issuance will be at prices at least matching NAV at the time of issuance. Its amended request that the SEC exempt it from rules against making investments with affiliated funds suggests that a complex array of related funds, managed by the same manager that manages Apollo, participates in transactions involving investments broader than Apollo's targeted debt investments. The fee structure of Apollo's manager is based both on the total assets under management and on quarterly performance - rather than per-share metrics - which may help explain why shareholders' assets per share are of so little import to management.

Why pay nearly 8% for the management Apollo appears set to deliver when American Capital Agency's historic results seem readily available at a lower price in American Capital's newer fund American Capital Mortgage Investment? Double-digit dividends and tax-free NAV increases due to accretive issuance are much friendlier to shareholders than what Apollo appears poised to provide, and I've jumped ship.

Of course, American Capital Mortgage Investment isn't the only better post-crash investment. In Part III of this series, we'll look at another. But for people willing to tolerate the risks of Apollo Investment, American Capital Mortgage offers superior management at a discounted price.

Continue to Part III >>

Disclosure: I am long ACAS, AGNC, MTGE.

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