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A number of the alts presented at the Goldman Sachs Financial Services conference this week. Here are a few random thoughts I had on their presentations:

(1) Apparently Leon Black and Steve Schwarzmann have lunch each quarter. Wonder who pays. I have not yet been invited. I assume they are both readers of this board, so I'll let it be known that I am open to an invite.

(2) There are still some huge markets out there. Insurance is a huge market that only APO has taken significant advantage of so far. Credit remains a huge market. Real estate/real assets is a huge market. I am not particularly optimistic, but 401(k)s and IRAs would be a huge market.

(3) APO and BX seemed a little more reserved about C-Corp conversion than previously. My expectation is still that both will convert, but my confidence level on that has gone done. I don't factor conversion (or non-conversion) into my investments on these. Need to be comfortable either way.

(4) Leon Black discussed valuation by working from FRE. He mentioned FRE of almost $2, but I use $1.92 for my purposes. At today's prices, the stock is trading at about 14x FRE. Mr. Black said it was trading at 15x FRE and now 12x FRE. Then, incentive fee for free and balance sheet for free.

In discussing valuation, he also said the market doesn't value incentive fees. I think it is true that the market doesn't value incentive fees as highly as FRE. All the valuation write-ups I have seen value it lower. But, I also think that the cyclicality of the incentive fees plays into the incentive fee valuation (or lack thereof). If the incentive fees should be valued at 8x, the question then becomes 8x of what. 8x of the $1.50-$2 Mr. Black says? 8x of the anemic incentive fee of the most recent quarter?

(5) I think the capital light model continues to be under-appreciated. Steve S. made a big deal of it at the BX investor day, and I think he is correct to do so. They can pay out over 80% and grow double-digits. You just don't see that a lot. Either a cash-cow or a fast grower. But, a grower that also throws off cash like that is unusual.

Anyway, returns in the alts haven't been any good this year. The companies I follow still are doing well. I continue to like APO the best. Even though I am critical of excessively discounting incentive fees, I do have to say one of the big things I like about APO is the base of FRE.

GnV
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To clarify: "The companies I follow still are doing well." I mean the businesses themselves, not the stock price. Not sure if that was clear in the original.
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Great post, thanks.

(1) Apparently Leon Black and Steve Schwarzmann have lunch each quarter. Wonder who pays. I have not yet been invited. I assume they are both readers of this board, so I'll let it be known that I am open to an invite.

We know Leon likes to order off of a "Chinese menu" but I don't know what is Steve's preference. **

(2) There are still some huge markets out there. Insurance is a huge market that only APO has taken significant advantage of so far. Credit remains a huge market. Real estate/real assets is a huge market. I am not particularly optimistic, but 401(k)s and IRAs would be a huge market.

High net worth investor and family offices are a juicy target. I think Blackstone is going to do quite fine with rich, richer, and richest personal investors.

(3) APO and BX seemed a little more reserved about C-Corp conversion than previously. My expectation is still that both will convert, but my confidence level on that has gone done. I don't factor conversion (or non-conversion) into my investments on these. Need to be comfortable either way.

Indeed, the bar for C Corp conversion is quite low for ARES and KKR but much higher for other firms given their mix of FRE and capital distribution focus. I'm glad that Leon is acknowledging the true cost of the C Corp conversion. I'm also concerned that corporate income taxes could rises, albeit modestly to 25% or so. Another headwind for the C Corp conversion ship.

Honestly I'm not even sure if I want BX and APO to convert. The real cash tax loss is forever and on-going but the multiple expansion can expand and contract as Mr. Market waxes and wanes.

(4) Leon Black discussed valuation by working from FRE. He mentioned FRE of almost $2, but I use $1.92 for my purposes. At today's prices, the stock is trading at about 14x FRE. Mr. Black said it was trading at 15x FRE and now 12x FRE. Then, incentive fee for free and balance sheet for free.

I believe in the past Leon and the Apollo founders have suggested applying a multiple to the "average expected" incentive fee. Cyclicals should not be valued solely on peak or nadir earnings whether it's cyclical auto manufacturing earnings or oil profits or incentive earnings.

5) I think the capital light model continues to be under-appreciated. Steve S. made a big deal of it at the BX investor day, and I think he is correct to do so. They can pay out over 80% and grow double-digits. You just don't see that a lot. Either a cash-cow or a fast grower. But, a grower that also throws off cash like that is unusual.

THIS. THIS. YES.

Nobody except you and me and the Tiger Global guys care.

https://www.sec.gov/Archives/edgar/data/1167483/000091957418...

ET

** Alt asset manager fanboy bonus points if you get the reference.
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so why does nobody care about BX stock then?
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so why does nobody care about BX stock then?

Do you mean why are certain board participants focusing on APO rather than BX?

Or do you mean why does Mr. Market value BX where it does if Blackstone is supposedly such a great business and investment opportunity?

ET
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The latter, I mean investing pros are pretty familiar with BX and their CEO and this business model.
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The latter, I mean investing pros are pretty familiar with BX and their CEO and this business model.

Well, this is a statement that can be applied to practically every company listed on the NYSE. There are not too many undiscovered NYSE stocks. Like most potential investments, Blackstone bulls think the stock is "misunderstood" while bears or investors bystanders think it is fairly valued or worse.

If the stock is fairly valued (or overvalued) then I think it boils down to fundamental disagreements about the future cash flows of Blackstone and alt asset managers.

It's fairly valued at current levels if one thinks the management fees of the business will stagnate or, even worse, reverse. Blackstone and other alts charge hefty management fees compared to SP500 funds or long only institutional managers. Nothing close to the 200 basis points some accuse alt managers of charging but still, let's call it about 100 bips.

So if you think management fees are a melting ice cube then it's fairly valued.

Back in the day I had a modest investment in a NYSE specialist firm called Van Der Moolen. It was a good business until it wasn't.

Furthermore, incentive fees are poorly valued by the market. This is understandable to a degree since they are variable and in the short-term highly influenced by market fluctuations. In the long term, all of these alt firms have crystallized incentive fees for practically every generation of PE funds (excepting some specialized funds).

Finally, there is the age old argument about whether K-1 status has been a detriment to the valuation of alt asset managers. KKR and ARES have switched to C Corps but not for a very long time. I am reluctant to draw any conclusions about the conversion particularly in an agitated market. It's fair to say other traditional asset managers have been punished in this market too.

Honestly, I don't think it matters for the K-1 alt firms. If the cash flows are as the bulls hope and they are paid out then I win. If the cash flows don't materialize, they won't be paid out. Then I lose. Whether or not the market values these cash flows at a level that makes me happy or sad doesn't really matter unless I need to sell in the meantime.

There are plenty of other "smart" investors now moving into alt managers but I don't really care about that either. If Tiger Global agrees with me about Apollo - fantastic. If they don't, okay. That ValueAct has established a significant position in KKR is a flower in the lapel for alt asset manager bulls but they could reverse their position. Que sera sera.

As I see it this are very sticky businesses with permanent or long-term capital that can grow at double digit rates with very little marginal invested capital required. Sooner or later the market will come around to this conclusion but if it never adequately does so be it. As long as the cash flows are paid out and they are bountiful I'm happy.

In the end, you look for variant perceptions and if you find such opportunities, you buy.

ET
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Well, this is a statement that can be applied to practically every company listed on the NYSE. There are not too many undiscovered NYSE stocks. Like most potential investments, Blackstone bulls think the stock is "misunderstood" while bears or investors bystanders think it is fairly valued or worse.

Amen. I mean, Warren Buffett (fairly well-known) thinks Berkshire (fairly well-known) is undervalued and is buying it. And it's more richly valued now than it has been in nearly a decade.

Different strokes for different folks...
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I see that APO hit ET's $25 today. I'm not sure if he added or not. In any event, another reminder for me to make sure I buy cheaply enough. That is not only an APO statement, but an all stock statement. Of course, "cheap" varies depending upon the stock. I'm not necessarily saying any specific metric, such as low PE. Rather, a high enough risk-adjusted return estimate bar, however you measure that.

In the case of APO, as ET alluded to, the distribution is significant. At $25, I think it is cheap enough even if some things go wrong. About 13x FRE makes it reasonably priced on FRE alone, and given the pipeline of FRE growth, I'd be pretty surprised if that didn't continue nicely for at least the near-term future. If I get a roughly $2 and generally growing distribution from a $25 price, things will work out ok. Not true at every price. Thus, "buy cheap enough".

-----------------

On market valuations, BX was valued highly at the IPO. Others have been valued much higher in the past. For example, APO was at $32 back at the beginning of 2014, when AUM was roughly 60% of what it is now. So, the market was giving APO a bit better valuation then. What was different then was that incentive fees were flowing in and the distribution was very large.

This goes back to a point I tried to make the other day, but don't think I made clearly. It may be that incentive fees are rewarded when they happen and disregarded when they don't. While I agree with Leon Black, that the market should value them on some cyclical multiple. In the very brief history we have, it seems like they were/are valued as they happen. That is, when the incentive fees are there, they are given value. When they are down, the market value is taken away.

Although there is a lot of talk about FRE, it may be that APO doesn't actually get much of a valuation until incentive fees hit, and the distribution drives the price up.

Those are just some thoughts. I have no great insight into how the stocks will trade.
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I see that APO hit ET's $25 today. I'm not sure if he added or not.

I am a man of my word.

ET
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It may be that incentive fees are rewarded when they happen and disregarded when they don't. While I agree with Leon Black, that the market should value them on some cyclical multiple. In the very brief history we have, it seems like they were/are valued as they happen. That is, when the incentive fees are there, they are given value. When they are down, the market value is taken away.

Josh Harris made the same point at the Deutsche Bank Global Financial Services conference in May 2016.

And so over many, many cycles -- and one of the reasons why the LPs give us a lot of money is that -- we've generated lots of cash flow in that business. We just can't tell you when.

When is going to be dependent on the value of our investments and the underlying market condition. But on average, that [INCENTIVES] business spits out about $2.00 per share of cash flow over a cycle. And what you see in the alternatives, which doesn't make a lot of sense, is that in times when the market is going down, and -- people tend to value the alternative at peak multiples when they are generating lots of cash out of their incentive business, and they tend to value the alternatives at trough multiples when they're not generating a lot of value out of their incentive business.

When you think about it over a cycle, the opposite should be true. And so for those investors that have more than a quarterly horizon, this would be really the time to buy the alternatives, because we've all sold a lot of stuff. And now we're building our portfolios, and the stocks themselves trade at trough multiples off of trough cash flow. And then kind of when you start to see the big dividend stream, which is inevitably going to come -- our large flagship fund is 53% invested and doing quite well -- maybe that's when you consider selling.


ET
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But on average, that [INCENTIVES] business spits out about $2.00 per share of cash flow over a cycle.

BTW, Harris meant $2/share of cash flow over a cycle PER YEAR, not total.

He just can't tell you when.

ET

P.S. Everyone disses the incentive fees cash flow stream but I bet those incentive fees largely paid for the 76ers and the New Jersey Devils.
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Might as well post the rest of the Harris quote from 2016:

And yes, that's not the way that we are generally valued in the marketplace. So today both the alternatives and Apollo are kind of valued, in my opinion, too low. And I would say that the -- when you add the $1.00 to $1.10 that we're making in our management business to the $1.85 that we made over the last cycle -- so just make the math easy, $1.00 and $2.00, you're at $3.00 of cash flow over a cycle. And you've got a stock that trades at $16 a share.

Not exactly apples to apples comparison because of the implied future growth rate of management fees may be different now versus a couple of years ago, but here's a quick comparison.

Mid-2016 Harris: 1.10 management fee (FRE) / 16 APO stock = 6.8% management fee income yield

Late-2018 Black: "almost $2.00 FRE" - let's call it 1.70 mgmt fee / 24.85 APO stock = 6.8% management fee income yield.

So at $25 or so we've once again come around to Apollo trading at a pleasing FRE yield. In my opinion it's trading at too low a multiple of FRE given the growth and stability. Add the potential incentive income and balance sheet for free.

Can it go lower? Undoubtedly.

As the market and Apollo have gone down, the boys at Tiger Global added to their substantial position at $28 and below.

No problema, señor.

ET
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So at $25 or so we've once again come around to Apollo trading at a pleasing FRE yield. In my opinion it's trading at too low a multiple of FRE given the growth and stability. Add the potential incentive income and balance sheet for free.

I agree with this.


Not exactly apples to apples comparison because of the implied future growth rate of management fees may be different now versus a couple of years ago, but here's a quick comparison.

Off the top of my head, I don't recall the outlook and circumstances regarding management fee growth in 2016. However, I think APO is reasonably well positioned to continue management fee growth from today. Organic growth in what they already have, such as Athene. Also, some significant new initiatives, like Athene Europe. I am optimistic about FRE growth in at least the near-medium term.

to the $1.85 that we made over the last cycle

I don't have a good read on the appropriate over-the-cycle, yearly number for incentive fees. Bigger funds, not as many bargains.

What do you think of the $2 number?

GnV
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What do you think of the $2 number?

Which 2 are we referring to with respect to APO?

I like the number two but I prefer the number eighteen. My younger son really likes 109 for some unknown reason.

ET
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$2 as an average for incentive fees for APO over the cycle.

One of my sons likes 13. Leaning in I guess. I prefer 25.
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$2 as an average for incentive fees for APO over the cycle.

I think $2/share on average per year is a very reasonable expectation for incentive fees for Apollo over the cycle.

2012 - $1.39
2013 - $3.68
2014 - $2.28
2015 - $0.54
2016 - $0.28
2017 - $0.85
Average 2012 - 2017: $1.50 per share


YTD thru Q3/2018: $0.29.
Average 2012 - 2018: $1.33 per share (presuming no realized carry for Q4).

Most of the carry is generated by PE. What will be the return on Fund VIII?

On average however there is more PE in the ground than before but the return may be lower than the stellar Fund VII.

Also more credit in the ground.

I think $2.00 is very doable. We are probably at the bottom of the incentive cycle.

ET
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On average however there is more PE in the ground than before but the return may be lower than the stellar Fund VII.

Yeah, it'll be hard to match 26% but 16% so far is not bad either.
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