As a solo punter / analyst, I do lack the team environment that accelerates learning. Twitter helps with that gap, though it hasn’t resulted in real life links that many other have benefitted from.
I mentioned a few days ago that someone implied from the price action of one of our holdings (Apollo Global) that interest rates rising will hurt the business. It pushed me to dig up more proof points about the business to understand whether this person is likely correct or not.
In doing that I got to better understand the business that I already know decently well. To that end, I came to the following conclusion(s), first with respect to the annuities spread earnings business which represents ~50% of ’21 earnings:
- Price / Spread: While annuities issues speak widely of the unique features / innovation in their products, I take the conservative approach and consider the product a commodity governed by lowest cost providers. Apollo repeatedly guides to their business model of almost perfect matching of assets of liabilities, so one can assume that in low or high rate environments, they will sell as much as they believe they will have assets for that clear a 15% annual cash on cash hurdle. Thus as a base case I don’t expect Apollo to widely benefit from wider spreads as rates rise, though that may be the case depending on how competition responds. Existing annuities are exposed to a modest amount of floating rate assets (~20%) with interest rate floors. To the extent that rates rise, legacy originations may see higher spreads.
- Quantity: The attractiveness of annuities rises as rates rise, as does a high yield savings that yields 3% vs 0%. One can reasonably assume that demand for annuities will rise as rates rise. This feeds into the above price discussion. Demand may drive higher spreads, but one can more reasonably assume that Apollo will be able to originate at least as much in terms of liabilities than it does today.
- Defaults: While there is some spread optionality on legacy issuance as rates go up via floating rate debt, one has to balance the increase in potential defaults as the cost to service and refinance rises and some potential borrowers cannot afford the refinance. It’s irresponsible to presume a single investor can evaluate the credit quality of a $300B debt portfolio.
Overall, I personally conclude that rising rates should be overall net positive for the annuities business with the caveat that like any financing business, one has to trust the management team that they are originating good assets that are durable in downturns.
The other part of the business, the asset management business, is roughly 70% derived from the annuities business and associated credit co-invest sleeves. The remaining 30% is 20% opportunistic equity (PE and the like) and 10% hybrid. I can’t speculate on what rates will do to LP appetite in the future. But as a smaller portion of the business, that is already guided towards lower growth over the next 5 years, and more focused on opportunistic equity versus a substitute for bonds, I am less concerted with rates rising affecting future fundraising here.
Net-net, I very much appreciate the questioning of the business model, and it has forced me to re-think the business model. But at this point I believe management’s comments that they would be excited to have a higher rate environment.
Note: We own shares of Apollo Global. Do your own work.