Brookfield Asset Management's Edge Among Alternative Asset Managers

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About: Brookfield Asset Management Inc. (BAM), Includes: APO, BX, CG, KKR, OAK
by: Dry Powder
Summary

The large alternative asset managers (AAM) are currently inexpensive despite experiencing some tailwinds.

I believe that not enough attention has been paid to BAM’s unique structure of listed partnerships, which offer a long runway to grow fee-bearing capital at industry-leading margins.

In addition, BAM stands out among the AAMs because its large balance sheet of real assets provides downside protection.

Executive Summary

I am recommending a long position in the Canadian alternative asset manager Brookfield Asset Management (BAM). BAM is a value-oriented alternative and real asset manager with $138 billion of fee-bearing capital under management.

The large alternative asset managers (AAM) are currently inexpensive despite experiencing some tailwinds. While BAM is no stranger to the value investing community, I believe little attention has been paid to BAM’s unique structure of listed partnerships, which offer a long runway for BAM to grow its fee-bearing capital at industry-leading margins. In addition, BAM stands out among the AAMs because its large balance sheet of real assets provides downside protection.

There is not a single transformative catalyst for BAM. Instead, there are several near-to-medium term actions that can improve BAM’s market value. Longer term, BAM’s superior structure and growth prospects may leave it the winner among large AAMs.

AAM Industry Recent Trends

AAM inflow growth is outpacing traditional asset managers

The AAM industry is growing faster than other asset management industries. Both debt and equity have been abundant for the last several years. Funds have been flowing in from endowments, pension funds and sovereign wealth funds. In addition, the industry is seeking more resources, and is now targeting high-net-worth individuals; eventually, large AAMs expect that individuals and retail investors will become major contributors to future fee-bearing capital [1,2].

Most growth is going to the large, established AAMs

Business is sticky, and reputation and size are critical. Fee-bearing capital is growing industry-wide, but the largest firms are capturing a bigger share of this business. Nearly 2/5th of funds raised in 2017 went to the 20 largest firms. Investors are accepting lower returns as long as they are safer returns. Large, established firms offer investors a higher probability that funds will be deployed. More assets also mean that deals are larger and targets have less upside and lower IRR. The move toward larger IRR has led to AAMs lowering targeted returns. In short, AAM investors are willing to accept lower returns as long as they can deploy large amounts of capital with reasonably safe returns [3].

Private funds are getting longer lives

Private funds are getting longer lives. There is a trend to lengthening investment periods so that they can withstand cycles. This is very important, especially lately, because current prices are high for entering an investment, and as a result accumulating dry powder can be deployed for later and for longer periods in long-lived funds. As of 2018, CVC began offering a 15-year fund period and many firms are developing open-ended or “perpetual” funds. Long-lived funds help AAMs because they allow firms to be more patient rather than give in to mediocre opportunities. Other benefits to long-lived funds that Bain points out include fewer transactions and transaction costs; less distraction/fewer execution risks by management; investing a larger amount of fee-bearing capital over longer periods; opportunity to exit investments at optimal times. In addition to longer-lived funds, AAMs are also increasingly focusing on open-ended “perpetual” funds [1].

More firms are hedging through partial exits

Partial exits - selling a portion of a company while retaining some ownership - are increasing (example: GrafTech). Partial exits allow a manager to return capital to investors while maintaining a stake in a company that they understand well and have confidence will outperform.

Dry Powder is accumulating

Dry powder is growing and is currently north of $2T globally[4]. The large amount of dry powder is indicating that there is a lot of competition for purchases and that there are not a lot of opportunities currently at attractive prices. Clearly, private capital is saying that they are bearish on a wide variety of opportunities at these prices.

Co-investment

Very large investors are increasingly turning to co-investment or very large separately managed accounts. In doing so, they are investing larger amounts of fee-bearing capital for longer periods of time and becoming reliable large business for AAMs. However, these investors pay lower fees while gaining experience with private capital investing with the ultimate goal of becoming independent private investment. Long term, I expect co-investing to be a negative for AAMs attracting very large investors.

True active investment is doing well

Finally, there is a trend toward passive in the investment management industry as it is becoming clearer that few active managers selecting securities truly beat the market averages over time after costs. With the exception of PE Hedge Fund business, I think that AAMs are safe from the move to passive for years to come. The work that goes into managing infrastructure - perhaps the largest market going forward [5,6] -cannot be made passive the same way that stock picking can. There is a great deal of work including diligence, management improving and exiting involved in real asset or buyout management that makes this business necessarily active.

In summary, despite ultra large investors wanting lower fees and more experience in the hopes of ultimately becoming independent AAMs (co-investment) and despite high multiples limiting investment currently, I think that most of the large, truly active AAM players should experience growth for years to come.

Players

Blackstone, KKR (NYSE:KKR), Carlyle, Apollo and BAM are all large publicly traded AAM firms. BAM is different from its competitors because of its asset classes, its large balance sheet, and its structure. BAM is not involved in the declining Hedge Fund industry and is selective in its exposure to debt investments. It has $30.8 billion of assets on its balance sheet and a large portion of its (and its investors) holding are real assets that offer a degree of recession safety. Finally, and perhaps most important, BAM has positioned itself so that it can more easily grow high-margin, fee-related earnings faster than (and possibly even fee-bearing capital) its competitors through its IDR paying listed partnerships.

AAM firms typically offer a SOTP valuation of their book value, fee-related earnings (FRE) and carried interest during presentations in order to illustrate how undervalued they may be. My issue with this approach is that typically much of FRE is lumpy and carried interest has a great deal of uncertainty built into it; and I think that the market agrees since no firm is getting much of a multiple on their carried interest. Comparing the companies after stripping outperformance FRE and carried interest on their balance sheet, balance sheet/market values are approximately:

BX: $8.45/$33.5; APO: $2.5/29; CG: $0.8/$18; KKR: $15.57/$23; BAM: $30.8/$46.

Non-performance FRE per fee-bearing capital (TTM) is:

BX: 0.89%; APO: 0.75%; CG: 1.0%; KKR: 1.4%; BAM 0.9%.

Margins on FRE are approximately:

BX: 50%; APO: 55%; CG: 25%; KKR: 40-45%; BAM 60-65%.

Both KKR and BAM have good downside protection based on their balance sheets. KKR has a much higher adjusted FRE/fee-bearing capital than its competitors, however a very large portion (~40%) of this revenue comes from transaction fees which have skyrocketed over the last two years so there is some concern that this portion of the business may be lumpy going forward. Finally, BAM has the highest FRE margins of the group. While KKR and BAM trade for nearly the same price/book, I believe that BAM’s more predictable revenues and higher margins make it the better business.

While the comparison above focuses on non-performance FRE, it is also important to note that a significant portion of BAM’s performance FRE is relatively predictable because it is based on IDRs.

Brookfield’s Strengths

BAM is primarily a real estate and infrastructure firm; the company does buyouts and limited private credit (more on this later) but management emphasizes that BAM does not want to be the biggest AAM by simply growing in all directions. Instead, it aims to stick with the sectors where it can deliver high returns to investors. I view the fact that it is choosy with PE and private debt as distinct positives; BAM limits its exposure to overly competitive (takeovers) and low margin (private debt) business unless it is confident of success. Instead, most of BAM’s assets are real, necessary and carry a good deal of tangible value. I believe these assets will do well regardless of cycle concerns. For example, retail and office real estate will correlate with the broader markets in case of a recession, but I believe that by being small and picky about its PE and credit businesses, BAM’s portfolio can weather a recession better than its competitors.

In addition to being rather cycle-resistant, BAM’s holdings are geographically diversified. According to management the company only operates in countries that, "respect the rights of capital” and it claims to “be everywhere they want to be.” BAM’s holdings are conservatively financed using mostly fixed-rates at the asset level with little (5%) BAM-level recourse and debts are denominated in local currency. Infrastructure revenues have inflation escalators also in local currency. BAM has $10.6 billion in debt at the corporate level ($6.4 billion fixed-rate avg 4.5%, 10 year and $4.1 billion avg 4.2% perpetual preferred). In short, I think that if there is inflation, the company will suffer some lag but its assets will pull through, and this would offer a nice exit opportunity with inflated asset prices.

But the most important aspect of BAM’s upside, in my opinion, is its network of listed partnerships. The listed partnerships are open to a much wider class of investors who are interested in receiving a stable, growing distribution but may otherwise not be able to invest in AAM niches. Right now (excluding BBU, which is the buyout partnership) they pay a mid-single-digit distribution and aim to grow distribution by a realistic mid-to-high single-digit rate. They offer relatively safe but growing income, something that fixed income has not been able to do lately. I believe they are a relatively good product for income investors and the fact that BAM has a majority of its balance sheet in its own listed partnerships keeps BAM aligned with listed partnership investors.

For BAM, the listed partnerships accomplish several important goals/trends of AAMs discussed above. Listed partnerships are (1) effectively perpetual in nature (2) they offer the opportunity for partial exit (and entry when there is a sizable discount to NAV) (3) they guide to realistic distribution increases and therefore effectively set a de facto low target return rate and (4) they allow BAM to raise funds, when appropriate, by issuing equity. The combination of these factors makes the listed partnerships inexpensive vehicles to raise funds and the lower hurdle rates mean that the company can surpass its targets with much more capital than competitors with higher targeted returns.

While the guided distribution increase for listed partnerships is not a hard target like a private fund would have, it sets realistic expectation for the investor. The result is that BAM has set up a platform, which is a satisfactory investment for low volatility income seekers. Raising capital through public entities is much more efficient than raising private funds. Large amounts of money can be efficiently raised for BAM through these listed partnerships as we saw with the issuance of BPR to purchase GGP. In total, BAM has found a way to earn high margins on large amounts of fee-bearing capital. The partnerships pay BAM IDRs, which will provide very strong growth for BAM’s performance FRE going forward. Importantly, IDRs are a much more stable form of revenue than the carried interest the competitor AAMs rely on for a majority of their performance income.

To give an example of how valuable IDRs are, consider that BAM expects to earn $259 million in IDRs in 2019. The 4th quarter earnings slides neatly lay out the hurdles, distributions and outstanding units of the major partnerships. BAM guides to 5-9% annual distribution growth. BPY/BPR recently surpassed its second IDR hurdle and is set to grow dramatically. If distributions in BEP, BIP, and BPY/BPR grow just 5%, which is the low end of guidance, next year’s IDRs will be $306 million or 18.2% greater; a 7% increase, which is near the middle of guidance, results in IDRs of $324 million or 25.2% growth. Importantly, these figures are conservative because they do not factor in growth in the number of listed partnership units or any contribution from BBU (which has market performance-based IDRs) or TERP, which is small.

Valuation

The following valuation neglects any changes due to the addition of Oaktree, which is discussed in a later section. My upside approach for valuation is a SOTP of book value and the DCF for base FRE and IDRs. BAM lays out a 5-year guidance during its investor days. This model is substantially different from BAM’s model in that I model lower growth in fee-bearing capital and neglect any value for carried interest. The main difference is that this model predicts a much higher - though still possibly conservative - growth in IDRs.

Here I assume a 7% distribution growth in listed partnerships. This is roughly in the middle of where BAM guides distribution growth. That said, my model is rather simple and only accounts for BPY/BPR, BEP, and BIP; the model does not account for IDRs in TERP, which is small, or in BBU, which is based on market prices and therefore too hard to determine. In addition, the model does not consider any increase in units, though there will surely be an increase. For example, $1.8 billion of capital securities issued to purchase Canary Wharf will eventually be converted to the BPY units. And of course, there will likely be other purchases with some equity financing. Assuming a constant unit count and neglecting BBU, if distribution grows at 7%, this would be an IDR CAGR of 19% over 5 years and 16% over 10 years. Another way to look at this is in order to grow distributions at 7%, the listed partnerships must grow FFO at least (7%*4/3=9.3%), which is not necessarily easy, but a lot easier than what private opportunistic investors expect. Therefore, this growth should be a lot more achievable with a large amount of invested capital.

The company guides a 14% CAGR growth in fee-bearing assets over the next five years as well as slight growth to 1% base management fees. My upside model is more pessimistic, assuming a 12% CAGR in fee-bearing capital. To put the growth in fee-bearing capital into context, over the last 6 years BAM has gained $98 billion of inflows (net of outflows and valuation changes). If one takes the required FFO growth of 9.3% - which would be needed to sustain the 7% listed partnership growth - as a metric for valuation growth, BAM could easily surpass my 12% assumption. In other words, I think that a value of 12% growth is a relatively conservative assumption that can be achieved assuming some slowdown of inflows, valuation growth, and multiple compression.

The model assumes base management fee revenues stay constant as a function of capital (0.9%) whereas BAM guidance suggests an increase to 1%. There is a plausible reason why base fees would increase: relatively high fee-listed partnerships (1.25%) grow as their market caps grow. Of course, the trend for increasing co-investment likely means lower base fees for the large private funds and may possibly offset overall fee revenues per fee-bearing capital. The model assumes constant 60% FRE margins. These margins can credibly rise as listed partnerships and co-investments remove much of the fundraising effort and offer the opportunity to hold investments longer. The model uses company guidance that for the next 10 years BAM pays a total of $600 million in interest and taxes at its corporate level (it has proven to be tax-efficient). After that, 25% of FRE and IDRs go to interest and taxes.

Assuming the above growth rates and margins persist for 10 years, using a terminal growth rate of 3% and a discount of 6%, I believe BAM may credibly be worth as much as $91 billion or roughly $91/share. Using a brutal discount of 10%, the model values BAM at $54 per share. Both values are net of carried interest.

If things go very badly, BAM is protected by its book value of $30.8. If BAM failed to bring in any future private funds, it would still own a significant fraction of its listed partnerships and earn large base fees and IDRs. Therefore, it will be more owner-like than it is today, but BAM would earn an outsized return on valuable tangible assets which offer some recession resistance. In short, if BAM’s world were to implode, I think it should still be worth more than its current book value. BAM would still earn revenues of $1.7 in distributions, >$250 million in IDRs and almost 1% of market value from its listed partnerships alone.

Catalysts

While it is hard to identify a single major catalyst, BAM has several small to moderate levers to pull that can improve near-term market value. First, BAM announced in its 4th quarter call that it began to earn carry for the first time on its first flagship real estate fund (BSREP I) and its fourth flagship private equity fund (BCP IV) and that it expects to realize nearly $1 billion in carried interest in 2019, a value much higher than realized ($254 million 2018, $99 million 2017) or guided to previously. The increase in carry is an indication that BAM believes we are late in the cycle. However, the fact that it is realizing carry is also a positive because it indicates that BAM has returned original investment and preferred returns on these funds and there is a high likelihood of additional carry from these private funds. In other words, this is an indication that it can turn unrealized carry to realized carry and hopefully the market will give BAM some credit for this.

Of all the listed partnerships, BPY has the most obvious upside in the near term. The price/book of BPY is very low currently (0.6) and good execution in the form of leasing/re-leasing, buybacks and deleveraging can narrow the discount. Among the BPY-related events on the horizon are the BPR base fee holiday will end in August 2019; the dispositions of properties and repayment of debt, especially related to incremental malls; the purchase of $500 million of BPY units; conversion of $1.8 billion capital securities related to the purchase of Canary Wharf into BPY units; growing revenue through development pipeline.

Risks

I think that a large rise in interest rates would hurt BAM’s value proposition most. While I do not expect a rise so large and sudden that fixed income becomes competitive with BAM’s listed partnerships in the next few years, I do think it is important to be vigilant about this possibility. The result of a significant rise in interest rates would be that increasing fee-bearing capital will become more difficult and listed partnership market caps will fall. Although BAM’s debt is largely fixed rate and long term, refinancing will become more difficult if the rise is rapid. Finally, BAM could be forced into exiting investments during a period of low multiples. The mitigating factor in case of a large and fast rise in interest rates is that distributions IDRs should still offer BAM some relatively safe earnings.

BAM, its listed partnerships and Bruce Flatt have a cult-like following. It is hard to find objective material on Brookfield companies because message boards and even journalists seem to be bullish echo chambers. Anything that damaged BAM’s reputation would also damage a great deal of hard-earned faith in the Brookfield companies.

Multiples compress over a period when BAM is expected to exit at high multiples. The mitigation is that BAM is planning for this by accelerating exits this year. More importantly, it is structurally situated by having a large amount of dry powder and growing perpetual and perpetual-like (listed partnerships) funds.

Buying Oaktree

It was recently announced that BAM will buy Oaktree - initially 62% and may buy the rest at a later time. BAM will pay for OAK using 50% cash and issuing shares. I was surprised by this announcement. OAK is known for specializing in debt and BAM has said publicly that it is cautious of this sector and even disposed of a portion of its debt business recently. Despite the fact that BAM looks a little wishy-washy when you compare its public statements versus this action, I remain optimistic for the time being. First, this is a consolidation and fewer competitors is good for BAM (and all the other large AAM players). Second, although PE debt is not as high margin a business as other PE sectors, by growing in this area BAM is both diversifying a growing fee-bearing capital base, and in buying one of the best debt firms, it can be said that BAM is being selective in its exposure to this sector. Third, BAM can potentially benefit from gaining some large and loyal OAK investors. So for the time being, I am giving BAM and Bruce Flatt the benefit of the doubt that buying OAK is a shrewd and selective purchase that will be accretive before and after synergies.

References:

[1] Bain & Company, Global Private Equity Report 2018.

[2] McKinsey & Company, McKinsey on Investing 2018.

[3] McKinsey & Company, The rise and rise of private markets.

[4] Preqin, Private Capital Dry Powder Reaches $2tn.

[5] Macquarie Asset Management, The Way Forward 2019 Global Investment Outlook.

[6] Brookfield Asset Management, Investor Day Slides, Sept 2018.

Disclosure: I am/we are long BAM. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.