Carlyle: Why I Am Passing On The 3% Yield
Summary
- Carlyle's mixed quarter and cautious commentary signal a challenging near-term distributable earnings run-rate.
- CLO-related deferrals resulted in a c. $4 million headwind in Q1, with potential credit downgrades down the road set to weigh on the management fee outlook.
- The latest run-up seems to have priced in a recovery; investors may want to exercise caution here.
Carlyle's (NASDAQ:CG) considerable dry powder across private equity, real assets, and credit make me considerably optimistic about the longer-term outlook for realizations and fundraising. But in the near term, the stock looks a lot less attractive, having returned to pre-COVID-19 levels. I think the stock has now priced in a normalized scenario, which seems far too optimistic at this point. I would remain cautious for now as general business activity remains slow, and as a result, realization pace could also meaningfully slow, putting some pressure on the distributable earnings outlook. CLO risks are also worth monitoring heading into the upcoming quarters, though the c.3% distribution yield does provide some downside protection.
A Mixed Quarter Warrants Caution on the Near-Term Outlook
CG's distributable earnings per share of $0.48 were ahead of consensus, although underlying distributable earnings were closer to c. $0.39 after accounting for a $30 million recovery of litigation costs. In that sense, I saw the latest set of results as mixed, with muted realizations, modest declines in fee-related earnings, and lower accrued performance revenues weighing on results. On the bright side, CG did pay its fixed dividend of 25c in Q1 '20 and did not guide toward any changes to the current run-rate.
Source: Carlyle Earnings Presentation
Portfolio declines: Declines in portfolio marks were expected, but the extent of the drawdown was a negative surprise. Real asset carry fund returns declined 12%, while Corporate Private Equity fell 8%, and Global Credit saw the steepest declines at -21% due to its exposure to energy mezzanine and structured credit funds. As a result, the in-carry ratio (% of Remaining Fair Value in an accrued carry position) declined to 36% from 54% last quarter, as Europe Partners IV, Global Partners, and International Energy Partners fell out of carry.
Source: Carlyle Earnings Presentation
Fundraising: Surprisingly, there were no changes to the previous $20 billion year-end guidance, though CG management did point out some LPs are evaluating their current allocations. However, the fact that LPs are still continuing to fund current commitments is a positive, with management highlighting several sizable capital calls within credit funds that were successfully made in full. In aggregate, CG raised $7.5 billion this quarter, well above last quarter's $3.8 billion, with a notable $4.3 billion in inflows coming from the investment solutions business. It's worth noting that CG has a lot of dry-powder at $74 billion, which is well above most of its peers relative to its size.
Q1 '19 | Q2 '19 | Q3 '19 | Q4 '19 | Q1 '20 | |
Total Available Capital | 77,000 | 71,000 | 72,000 | 69,000 | 74,000 |
Source: Company Data
Exposure: Corporate Private Equity exposure to stressed sectors remain relatively modest, with management disclosing the major ones being commercial aviation at 7% and retail at 5%. As c. 7% of the corporate PE portfolio is public, mark-to-market valuation adjustments should also be limited. The US Real Estate portfolio has an even lower contribution from stressed sectors, with c. 2% in hotels, c. 2% from the traditional office, and c. 1% from retail. The risk remains in energy, with firm-wide exposure currently at c. 9% (including c. $13 billion of fair value in largely dedicated fund structures and c. $4 billion of available capital for deployment).
Clawback: Meanwhile, clawback risks also remain under control for now, despite four funds (Europe Buyout IV, International Energy Buyout, Long-Dated, and Credit Opportunities) falling below carry in the quarter. Specifically, there was no change to year-end clawback levels, nor does management expect a material change should the net accrued balance decline from current levels.
It's important to note that our accrued clawback remained insignificant and unchanged from year-end. And while it's possible that our net accrued carry could further decrease, should values continue to decline, we do not expect a material change in our accrued clawback.
Guidance Withdrawn, Outlook Uncertain
In conjunction with the withdrawal of headline guidance numbers, fundraising expectations are lower, and deferrals in subordinated management fees from certain CLO vehicles will weigh on fee-related earnings (FRE). The updated core FRE guide is now within the $400-450 million range for the full year, down from the prior $475 million and compares to the $478 million annualized rate in Q1 '20. This was a negative surprise considering FRE is generally predictable, with c. 90% of fee revenues tied to traditional closed-end/long-dated funds, which have little exposure to fund valuations.
Source: Carlyle Earnings Presentation
The key difference this time around is uncertainty around its collateralized loan obligations (CLOs). CLOs, typically, generate management fees on the senior tranches (c. 30% of the total fee structure) and on the subordinated tranches (c. 70% of the fees). The senior tranches fees are unlikely to be deferred in this cycle, but the subordinated tranches are a risk, with CG already deferring fees on these lower tranches in Q1 '20. As subordinated fees are typically paid if the CLO is in good standing (as determined by the underlying credit ratings), the c. $4 million deferral on subordinated fees is a negative signal. Notably, the deferral accounted for the vast majority of the Q/Q delta in management and advisory fees within global credit.
Global Credit | Q1 '19 | Q2 '19 | Q3 '19 | Q4 '19 | Q1 '20 |
Management and advisory fees | 74.8 | 79.2 | 75.6 | 77.6 | 73.0 |
Fund management fees | 1.1 | 1.2 | 1.1 | 1.3 | 2.3 |
Portfolio advisory fees, net | 1.8 | 2.2 | 1.4 | 4.5 | 0.3 |
Transaction fees, net | 77.7 | 82.6 | 78.1 | 83.4 | 75.6 |
Source: Company Data
The risk going forward is that rating agencies downgrade additional loans in CG's CLO portfolio, which would lead to more revenue deferrals for the full year. Now, this isn't a reason for panic, as CG recovered 100% of its deferred subordinated fees in the last financial crisis. I do expect a similarly high level of recovery in this cycle, but the loss of the subordinated fees will pressure fee-related earnings in the upcoming quarters.
During this quarter, we did not recognize $4 million of subordinated fees which were deferred. If the rating agencies further downgrade bonds and loans in which the CLOs have invested, it's likely that CLOs across the industry will experience revenue deferrals over the course of this year.
Stay Cautious
Considering management's cautious outlook on a fundamental business recovery on the Q1 call, I would think it reasonable to assume that both deployments and exits will slow in the upcoming quarters. The resulting slowdown in deployments will undoubtedly weigh on earnings, assuming fundraising for the next generation of flagship funds begin only once the current vintage hits a certain level of commitments from LPs. With plenty of macro risks on the horizon as well, private equity may opt for a more cautious approach to deals, slowing the pace of exits.
Following the recent rally, I view CG shares as overvalued relative to my $25 price target, based on a c. 10x multiple on distributable earnings. While CG is an industry leader and should remain resilient through the cycles, the current valuation multiple is too difficult for me to justify. The current c. 3% yield should provide downside protection, but considering the risks at hand, I am inclined to stay on hold.
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Comments (4)
But, yeah, "Stay Cautious" lol
Definitely a nice and appreciated analysis. Thank you.
