Carlyle Group: A Leveraged Bet On Private Equity

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About: The Carlyle Group L.P. (CG), Includes: BAM, KKR
by: Wubbe Bos
Summary

Carlyle is focused on asset management.

The lack of own invested capital increases the risk.

Good returns for private equity will result in great returns for Carlyle.

After writing about KKR (KKR) and the family of Brookfield companies (BAM) (BIP) (BPY) (BEP), some readers asked for my opinion and an article on the Carlyle Group (CG).

Carlyle Group is an alternative asset manager with assets under management (AUM) of $222B. Fee earning AUM is $160B, while $8.8B is pending fee earning AUM that will activate upon deployment. Given the market value of only $8.0B, you get a lot of assets under management for a relatively low market price, when compared to KKR or Brookfield Asset Management. In this article, I will analyse the Carlyle Group and value the company.

Value of Carlyle's asset management business

Given that asset management is fairly capital light, my valuation will focus on three main metrics. First is margins that are generated, second is the growth component, and last but not least the composition of earnings. Combining those factors can give more insight into the value of the asset management business.

Carlyle's margins

Over the last twelve months, Carlyle managed to earn $658M in net income. Given that Carlyle's AUM is comparable in size to Brookfield Asset Management and KKR, this level of earnings is somewhat disappointing. Still, Carlyle managed to earn 0.4% on its fee earning assets under management. In the first quarter of 2019, Carlyle managed to get fee-related earnings (FRE) margins of 26% and the company expects to earn FRE margins of 25% for 2019. These margins are lower than those of KKR or Brookfield Asset Management. Apparently, Carlyle charges lower fees or pays out more to management.

One of the primary reasons that Carlyle is not able to generate the same kind of margins is their investment solutions business with $45B in AUM. This division consists primarily of AlpInvest.

AlpInvest was acquired in 2011 from two large Dutch pension funds. AlpInvest was primarily managing money for those two pension funds and still does. The problem is that the earnings that come from managing these $45B in assets was only a paltry $32M in fee-related earnings and $10M in realized performance fees.

Carlyle Unitholder Presentation

Carlyle is aiming to improve the fees on these funds, but given the strong position of the Dutch pension funds, I think increasing earnings from these funds considerably is going to be difficult. The AlpInvest AUM also explains the $77B of AUM that is eligible for performance revenue.

Conclusion: Margins of Carlyle are good, but not as great as those of KKR or Brookfield Asset Management. This can partly be explained by the acquisition of AlpInvest. Margin improvement might be a possibility but could be fairly challenging. Net earnings of 0.4% on fee earnings assets is attractive.

Growth potential of Carlyle

Carlyle is one of the large private equity firms and has benefited from the tailwind of fund inflows that the private equity industry received. Asset under management have increased fairly quickly at a 25% rate, from $178B in 2016 to $222B in the first quarter of 2019. Carry available assets increased even more quickly at 35% to $77B. This is nice growth, but not market leading.

KKR, for example managed, to grow AUM 50% in the same time-frame. The difference in growth can again be partly explained by AlpInvest, which did not see much growth over this period. Another concerning fact is that the amount of shares outstanding at Carlyle is growing fairly rapidly. This is a concern that investors should keep in mind since private equity firms are known for their lavish compensation. This compensation through stock options can sometimes be hidden from the income statement, but reduce the future value of the shares.

Carlyle's quality of earnings

Alternative asset managers earn both asset management and performance fees. Given their nature, asset management fees are a lot more stable and therefore deserve a higher multiple. Especially with the stock market at an all time high, some caution seems prudent.

Carlyle itself is also focusing on the quality of its earnings. Since 2015, earnings have been under pressure, but fee-related earnings have increased. This shift from realized performance revenues to fee-related earnings increases the earnings visibility into the future and those fee-related earnings also deserve a high multiple. In 2018, Carlyle managed to earn $350M in fee-related earnings and for 2019, estimates indicate the company will earn $400M.

However, net realized performance revenues have declined from $789M in 2015 to $320M in 2018. Given the difficult fourth quarter, the 2018 result might be an outlier, but in 2016 and 2017, realized earnings was also declining. Still, net accrued performance revenue is relatively large compared to the competition. The main reason for this fact though is that Carlyle has relatively few own investment assets on its balance sheet.

Carlyle Unitholder Presentation

Given the growth in AUM, fee-related earnings, and pending AUM, I think a multiple of 17 times estimated 2019 net fee-related earnings of $400M is approximately a fair valuation leading to $6.8B.

The performance-related earnings, however, have shown a tendency to decline while the stock markets are at an elevated level. Using the average of the last four years results in average earnings of $572M. Given the declining trend and low earnings in 2018, I multiply these earnings by 7 to come up with a value of $4B.

The shift from performance-related earnings to fee-related earnings clearly helped the valuation of Carlyle's asset management activities. The growth in asset under management is impressive, but the question is how much growth is still left.

Private equity is clearly an investment that has grown in popularity given the need for investment returns, the retrenchment of banks, growth in sovereign wealth funds, and increased penetration in insurance and high net worth clients. This could mean that the AUM for the alternative asset management industry can almost double to $9 trillion in 2023. Given this growth of the industry and recent trends towards consolidation, it is not unreasonable to assume that Carlyle's AUM will reach $300B in 2023.

Carlyle's balance sheet value

Carlyle is more of a pure play asset management company than some of its competitors. This allows it to earn more net performance fees per share, but also means that the value of the company is less underpinned by balance sheet book value. Most of the book value is related to net accrued performance revenues, but investments are an increasing part of the value and are currently $1.3B. In total, the balance sheet values can, in my view, be valued at book value, leading to a value of $2.7B.

Carlyle Unitholder Presentation

Conclusions

Combining the value of the fee-related earnings, performance-related earnings, and certan balance sheet items leads to $13.5B. This is significantly above the current market value of $8.0B. However, there are some concerns regarding the Carlyle Group. Outstanding units have increased fairly rapidly, limiting the upside for investors. In addition, the company is very sensitive to a change in the popularity of private equity. Disappointing results could lead to lower performance fees and potential outflow. Carlyle Group does however pay an attractive dividend that yields 5.3%. This dividend is not stable, but historically investors in the Carlyle Group have received strong dividends, which correlate strongly with earnings.

Disclosure: I am/we are long KKR, 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.