The Irresistible Math Behind Private Equity Stocks – Forbes

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Leon Black, chairman and chief executive officer of Apollo Global Management LLC. Photographer: Patrick T. Fallon/Bloomberg

Why did one of the smartest hedge fund investors on the planet spend the early parts of 2017 buying shares in private equity giant Apollo Global Management hand over fist? To understand the reason billionaire Chase Coleman’s hedge fund Tiger Global spotted value in Leon Black’s private equity firm, look no further than the way in which it built a major stake in Apollo.

In early 2017, a large block of Apollo shares hit the market when two early investors, the California Public Employees Retirement System and Abu Dhabi Investment Authority, sought to trim their holdings. Surprisingly, the two mega-funds found a buyer in Tiger Global, best known on Wall Street for its large investments in technology firms such as , Priceline and . In a private deal, Tiger Global bought the shares of the selling investors, the foundation of a bullish bet on Apollo, overseen by Tiger Global’s head of public equity investments Scott Shleifer, which now makes the hedge fund its largest outside investor with an 8% stake worth nearly $900 million.

Tiger Global’s calculus involved a top-to-bottom review of Apollo and its earnings potential, but it hung on a simple fact: The hedge fund was buying shares at roughly the same valuation CalPERS and ADIA paid when plowing $600 million apiece into Apollo in the summer of 2007. In the ensuing decade of boom, bust and recovery, however, Apollo’s assets under management expanded roughly eight-fold to $197 billion, dramatically increasing the firm’s size and scope (and its fee earning opportunities). Apollo’s growth came on the back of strong performance in its PE funds, and new businesses such as re-insurer Athene Holdings and a credit investing arm.

“We purchased many of our shares from investors who acquired them approximately 10 years ago in private transactions at more or less the same valuation we are paying today, despite an 8x increase in AUM over that period,” Tiger Global told its investors in a recent update obtained by FORBES. (A Tiger Global spokesperson declined to comment.)

Spurred by the so-called ‘Trump rally,” many investors bought bank stocks after Election Day expecting interest rates were on the rise and financial earnings would boom. This trade has lost steam alongside the bond market and banks are slumping anew. But with little fanfare, private equity stocks continue to rally and there’s a big case to make that these are the financial companies to own over the long-haul, Trump trade or not.

Apollo’s publicly traded units offer investors a piece of its general partnership, meaning they earn money from the management fees and performance fees Apollo collects on the assets it oversees. Due to its partnership status (Apollo listed its shares on the New York Stock Exchange in March 2011), the firm passes on these earnings on to shareholders, similar to a pipeline master limited partnership or a real estate investment trust. This puts ordinary investors in the same position as Apollo’s billionaire co-founders, Leon Black, Joshua Harris and Marc Rowan, who derive the bulk of their earnings from the dividends they receive as shareholders.

In 2016, Apollo’s management fees hit a record $1 billion and its carried interest (performance fees) came in at $780 million. Add in $146 million in transaction and advisory fees plus gains on equity investments, then subtract expenses like overhead and bonuses, and Apollo generated $638 million in net profits for its shareholders, or $1.56 a share. It paid out 92% of this pot to investors in dividends; by using an end-of-year share price of $19.36 the firm paid a 7.3% yield in 2016. In today’s rock-bottom interest rate environment that’s a nice payout, but last year’s bounty may have been a trough.

Since Blackstone and Fortress listed their shares on public markets ahead of the financial crisis, most large PE firms have followed suit. KKR listed on the NYSE in 2010, Apollo in 2011; Oaktree and Carlyle listed their shares in 2012. While most of these firms have expanded rapidly,  their market valuations have been a disappointment.

Blackstone, the world’s largest PE firm, is barely above its 2007 IPO price despite having grown its assets fourfold via mammoth businesses in credit, real estate and now infrastructure. Carlyle trades below its IPO price. Like Blackstone and Apollo, Oaktree shares have barely budged over the years. KKR trades at the same price it did in 2011, and that’s after a 32% rally over the past 12-months.

This stagnation comes as record sums of money gush into the industry’s biggest firms. Much of the institutional and high net worth money being pulled from hedge funds and mutual funds flows into passive strategies, or those offered by the Blackstone’s of the world. Though these stocks have languished, investors have been well compensated with rich dividends. For instance, CalPERS and ADIA have done okay on their Apollo investment due to dividends. Tiger Global, however, was ready to bet Apollo’s valuation would eventually rise.

“With close to 30 years in business, a high-quality management team, enviable historical growth, and attractive future growth and cash flow prospects, we do not believe Apollo should trade at a lower multiple than other asset managers or even other technology businesses that have far less predictable futures,” the fund said in its letter. After initially disclosing a 13 million share stake in mid-March, Tiger was a steady buyer of Apollo shares through April and May as the PE firm climbed to multi-year highs above $26 a share.

Some areas of upside, according to Tiger Global‘s letter, include Apollo’s burgeoning credit arm. “We believe the company has the potential to be significantly larger in the future, particularly in its credit business. This segment has grown from $4 billion to $141 billion over 10 years but remains a fraction of the size of firms like Blackrock, which manage trillions of dollars but have achieved inferior returns.” About re-insurer Athene, Tiger characterized the unit as, “a brilliant acquisition” that gives the firm’s credit business a permanent capital base and associated fee streams.

And the hedge fund believes Apollo is set to thrive in a down market. “[W]ith roughly $45 billion of dry powder and a track record as one of the world’s premier distressed investors, Apollo is well-positioned to capitalize on an economic downturn, which would increase deal flow in an area where the firm has generated very high returns historically.”

Of the investment, Tiger Global concluded, “Over the long term, we believe we will earn meaningful cash on cash returns as shareholders of this business and will recover a significant portion of our cost basis in dividends by the time we sell our shares.” This year Apollo shares are up nearly 40%. Through May, Tiger Global is off to a hot start and up 23%.

So what is the market missing when it comes to PE stocks? They are new to markets and suffer from the complexity of a litany of non-GAAP earnings metrics. They also aren’t included in indices like the S&P 500 and come with arduous K-1 tax forms. But sector investors like Bill Miller IV, of the strong-performing LMM Income Fund, mostly point to the unpredictability of performance fees when investments are exited.

Take the past as an example: In 2013, Apollo was exiting its crisis-era investments – Leon Black called it “selling everything that’s not nailed down” – and performance fees on these winning sales pushed Apollo’s annual dividend to about $4 a share. It’s shares traded as high as $35 by early 2014; then investors abandoned the stock seeing that a new investment cycle was underway and fee-generating asset sales would not be coming for a few years.

In trough years like 2015 and 2016, Miller is happy with Apollo’s 7%-to-8% dividend, mostly driven by management fees. But he pencils out a future that looks similar to 2013, expecting a 45% total return from current prices. The math is as follows: Miller applies a market multiple of 18-times on Apollo’s management fees and a 9-times multiple on its expected performance fees ($1.85 is his estimate) and then nets Apollo’s corporate debt with the investments and carry on its balance sheet.

He views Apollo’s current share price of $27 as reflecting a belief the firm won’t be able to earn its historical returns on current and future funds. “We think that is just folly. I have not seen any evidence that there will be return compression,” Miller says. The sentiment is shared across the industry.

In fact, perhaps upside is even greater. Blackstone co-founder Stephen Schwarzman routinely complains about his stock price and recently valued his firm at $100 a share on an earnings call, three times its current price. How would one justify such a big valuation?

Blackstone’s best 12-month stretch of profits came in 2015 when it paid out $2.90 in dividends as its realized crisis-era investments and generated nearly $4 billion in earnings for investors. The stock rocketed as high as $43 a share. But here’s rub: Those performance fees were mostly earned from funds created when Blackstone was less than half its current size. Assuming steady performance who’s to say the firm can’t do far better than its 2015 windfall?

It’s not just Tiger Global or Stephen Schwarzman who are bullish on the business. KKR, more than any other PE firm, has been putting its money where its mouth is by aggressively repurchasing its stock. Like Apollo, it recently attracted a major investment from a top hedge fund, ValueAct Capital. In January, Fortress was acquired by SoftBank for a 38% premium, ending its disappointing run on markets.

Even after the rally, LMM’s Miller favors these PE stocks as financial bets with unbeatable dividend yields. “They are all cheap,” he says of the sector, finding Apollo and Carlyle Group to be the cheapest.

Talk of tax and regulatory reform has investor excitement over financials bubbling. There’s even a brewing discussion of adding private equity to 401k plans. For now, however, PE investments continue to be the domain of the rich and well-connected. But there’s a way to play the industry: Publicly-traded PE stocks are cheap and available to all investors, the smart money is waking up to these stocks.

Read Forbes’ Private Equity Coverage:

How Blackstone Became An Unstoppable Force

Brookfield: Toll Collector Of The 21st Century

Carlyle Group And The Kings Of Capital

How A Bet On Lyondell Became Wall Street’s Greatest Ever Deal

How Apollo’s Crisis-Era Bet On Annuities Turned Into A $72 Billion Business

Why Private Equity Stocks Can Double And Change Wall Street Forever Under President Trump

Some Of The World’s Biggest Hedge Fund’s Think Private Equity Stocks Are Cheap