Author: the_red_deer

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Bolt it On

Patria Investments, a portfolio company that I’ve written about in the past, announced that it added on a real estate platform via acquisition. Previously the CEO had hinted at such an action:

We already have 3 funds as I mentioned, down there in Brazil, in the Brazil Stock Exchange. And we also look for buying these — kind of these permanent capital structure funds through acquisitions through M&A. And if we do pursue M&A opportunities in the real estate arena, within real estate, there is several permanent capital structure funds in the region that were listed in the main stock exchanges in the region, Mexico, Colombia, Chile and Brazil, so we can also add these kinds of funds, not only organically, as I mentioned, but also through M&A.

PAX Q4-2021 Earnings Transcript

Today they described the acquisition:

Patria Investments (“Patria”) (NASDAQ: PAX), a global alternative asset manager, announced today an agreement to acquire VBI Real Estate (“VBI”), one of the top independent alternative real estate asset managers in Brazil, with approximately R$ 5 billion in assets under management across both development and core real estate vehicles. The transaction is structured in two stages, the first of which entails the acquisition of 50% of VBI by Patria. The second stage, when closed, will lead to full ownership and integration of VBI to Patria’s platform.

PAX Press Release

VBI has roughly 60% of its AUM via permanent capital structures (publicly traded REITs on the B3) and the rest via drawdown vehicles.

Overall, Patria has bolted on a real estate platform, credit platform, and growth equity platform to its existing PE and infrastructure flagships in a very short amount of time post IPO. Only time will tell if they are able to successfully increase distribution, cross-sell, and as well as maintain investment performance across these platforms. Time will tell.

Disclosure: We own shares of PAX, this is not investment advice. Do your own work.

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Watching Housing

Housing is on everyone’s mind these days for many reasons. One’s own home value, the value of a future purchase, but mostly, it is one of the single biggest markets (by dollars) around. And when a whale of a market turns, it changes consumer behavior (and the economy).

This morning, the weekly gauge for mortgage purchase applications went cliff diving:

On a longer term basis, here is how treasury yields have pushed mortgage applications around over time:

Generally with a topic like this, one’s own mind wants to be on one side of a fence or the other, not sitting on top of it. Housing is going to crash or housing will be fine. Perhaps it just hangs out in the middle of those two? Can’t print a news headline that sells with that.

Calculated Risk, a housing / core economic data blog who was on top of the housing bubble of the 2000s, has his outlook here (as of 5/13/22). I pasted the end of it below:

Calculated Risk

As such, his prediction is a middling situation (stall = nominal price growth, negative real price growth – so a home owner won’t see headlines that they are losing money), which isn’t what readers’ hearts want, but seems highly reasonable.

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The Minnow and the Whale

One of our holdings, Franchise Group, has been a part of a dramatic M&A process involving Kohl’s, the department store.

Yesterday they announced that they have a ~3 week exclusivity period under the guise of a ~$60 / share bid for the company. I’m doing this off the top of my head but Franchise has an enterprise value of about ~$3B to Kohl’s. As such, it’s a bit of a python swallowing a horse. Here’s the press release:

In reality, a large portion of Kohl’s enterprise value is represented by the dirt under it, the un-levered real estate. Franchise indicated that it intends on financing the deal with $1B from its credit facility, effectively cross-collateralizing other assets in its portfolio to fund the equity portion of the deal. It intends to fund the rest, I presume, with a sale-leaseback of the real estate and keep the existing Kohl’s corporate debt outstanding.

I have no opinion on the transaction, as I really have no opinion on any transactions that any of the private equity managers we are invested with (Franchise is effectively a publicly traded private equity fund) before they close. The investment was in the managers, and after the fact, we can evaluate whether they have been doing a good job or not. To evaluate something without any of the real behind the scenes data is for my own purposes, futile, as the premise in investing in them is they make investments that most people don’t see value in, thereby creating alpha / outperformance.

All we really do have is the following from the prior earnings call when asked about Kohl’s specifically:

FRG Q1-2022 Earnings Transcript

All we really have to go off of is their prior track record, which one could describe as adequate to very good to date with the caveat that it’s still early with Franchise being a newer company. Its most recent transaction was what one could describe as financial alchemy, as it executed sale-leasebacks on the real estate and sold the consumer receivables to reduce their basis to less than $0. What is less clear is their longer term ability to grow the businesses they own with repeatability – and this is more important than financial alchemy.

What is quite certain is the next month should be an interesting one for Franchise, and the next year, given all of the recent transactions, should be telling as to how they manage the materially larger portfolio than only a few years prior.

Disclosure: We own shares of Franchise Group, this is not investment advice. Do your own work.

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Transformation

As a follow up to yesterday’s post on AINV, I continued looking deeper into this as a potential little addition to our publicly traded levered debt companies that chunk out cash. Two things to note, first the current CEO of AINV is a co-founder and prior CEO of MidCap, so the association between the two is even closer than I thought prior. He took the CEO spot in 2016, when AINV received approval from the SEC to co-invest in affiliated investments (meaning invest in Apollo deals), and the prior CEO parted ways. Second, in going through past documents, the company used to post metrics in its progress from “trash fire” to a halfway respectable loan vehicle:

Based on the most recent earnings call, the management team has made it clear that core assets will only comprise of corporate lending going forward after aviation assets are liquidated (they are grouped in “core” above). For the most recent quarter, new corporate lending activity comprised of:

  • 100% first lien
  • 100% floating rate
  • 98% co-invested with MidCap
  • ~$7m average commitment size

This is roughly representative of what the AINV structure should look like within the next few years, a long way from the Dec-16 portfolio makeup above.

While AINV is far from the moonshot most stock investors aspire for, I think it may be a nice little loan pile to tuck into a liquid levered debt allocation if one’s portfolio strategy aligns. That said, an owner must be eyes wide open that these sorts of vehicles may materially detach from NAV during market dislocations. That’s all on this.

Disclosure: We don’t own shares of AINV at time of writing, this is not investment advice. Do your own work.

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Middle Market Lending

Today, debates rage on the marks of private equity and debt investments versus public markets. Ever the topic, public investors rail on private markets investors, indicating they don’t mark their portfolios down appropriately. They also bemoan the fact that…investors *prefer* the soft / no markdowns vs public markets.

Open-ended private debt vehicles often allow for redemption at par / net asset value (NAV) on a quarterly basis (they will typically offer to repurchase 5% of shares outstanding). An equivalent publicly traded debt vehicle is liquid on a daily basis, and can “only” be redeemed at what the publicly traded price is. Often times that varies widely between a discount or premium to NAV.

As an example, Starwood Property Trust – a publicly traded tier 1 property lending vehicle, traded pre-Covid from ~$25 / share to $10 / share in the depths of Covid. As it turns out, NAV for Starwood was largely unchanged pre/post crisis. While much drama happened in the massive market de-stabilization in midst of Covid and the resulting government action to stabilize capital markets, at no point could one buy a share in an equivalent private lending vehicle at such a discount nor would an existing holder see such a markdown on their statements.

Today, Apollo is out in market with a unique private debt vehicle (Apollo Debt Solutions) that primarily invests in private debt backed by large-cap companies (e.g., EBITDA >$100m), a smaller portion in middle-market companies, and a smaller temporary sleeve in liquid debt securities. As mentioned above, it’s private so entry / exit will likely happen at NAV.

Enter Apollo Investment Corporation (AINV). It is a publicly traded vehicle that trades in the ~$12 range / share with a NAV of just under $16 / share. Generally speaking, AINV has been a bit of a junky vehicle with plenty of second lien debt, oil and gas loans, etc. It traded down to ~$5 in Covid (yikes!). However, what is interesting about AINV today is it appears that the vehicle is turning direction to align with the broader simplified corporate strategy at Apollo. Going forward, it essentially is a co-invest vehicle with Athene’s MidCap platform, the middle market sleeve of Apollo’s debt platform. I would think of it as more a MidCap co-invest shell than the more autonomous vehicle it was before.

AINV has steadily reduced second lien debt and what was classified as non-core loans (oil and gas, etc.). MidCap has been a star in the Apollo lending universe and is a heavyweight middle-market lender in corporate loans, life sciences, and is pushing deeper into franchise / trade finance. Furthermore, its primary mission is to feed Athene’s regulated insurance balance sheet. Simply put, it has to originate good quality paper as it is being matched against annuities which in many cases carry guarantees of payment to the annuity holder. All of the assets are regulated by multiple insurance regulators (versus a shadow lending vehicle). But most important, MidCap has had 20bps of *cumulative* losses over 20 years, effectively zero. More recently, MidCap generally pays an 11-12% dividend on invested capital, and that temporarily declined to ~9% through Covid. As such, AINV of tomorrow may not be the AINV of today and yesterday. It may be better positioned as a publicly traded sleeve of MidCap. However, as a public vehicle, it offers a different value proposition, namely one that has the benefit of selling at a material discount to NAV but one that has no certainty on redemption value.

Extra spice doesn’t come without some burn. And as such, AINV is just one tool of many to gain levered private debt exposure, albeit with a much more credible value proposition than the past.

Disclosure: We may own shares in securities mentioned, this is not investment advice. Do your own work.

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Value Star

Cliff Asness of AQR was interviewed on Morningstar recently. He’s a bit of the prom king this year with respect to performance. While AQR has struggled this past decade, it dazzled year to date, with his main absolute return (multi-strategy) fund up 35% YTD through the end of May, while the S&P is down ~14% as of today.

What is more interesting is how Cliff views “value” today and its position vs the historical mean. More specifically, he measures “within industry” value, meaning the spread between statistically cheap and expensive stocks within same industries (e.g., cheap IT vs expensive IT). The cumulative measure of his “within industry” value spread has started to collapse, but still resides far from the mean:

Cliff’s Perspectives, AQR

With anything, one chart does not explain the future, but it’s just one more arrow in an investor’s quiver to aid in staying away from trouble.

It’s worth noting that Cliff isn’t a traditional value guy, he’s more a factor investor. His firm runs a multi-strategy fund including trend following / momentum, alternative risk premia (likely things like disaster insurance, life settlements, etc.), commodities, long/short, etc. So he’s not just another vanilla value investor banging the “things are expensive” drum without much insightful context.

While the business of predicting the future gets the most airplay during times of higher uncertainty, like now, the general saying goes is the only thing certain is that nothing is certain. With that certainty, we continue to re-invest modestly and move on with life.

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The Vertical Integration of Private Markets Investing

The GFC and resulting regulations have driven major changes across the financial services landscape, and as capital flows are driven out of public markets, the makeup of financial services across the spectrum from large to small companies is changing at an accelerated pace.

I previously wrote about how classic M&A boutiques are extending their reach by entering Capital Markets. Yesterday, I caught pieces of the Goldman Sachs presentation at the Bernstein conference (which has had great speakers). It made me realize that what I had previously written about regarding M&A boutiques was perhaps a smaller part of a larger shift.

I’ll call that shift the “vertical integration of private market investing.” I’ve listened to many Goldman presentations over the past year or two, but it’s admittedly been hard for me to wrap my mind around exactly what they are trying to accomplish. For whatever reason, John Waldron’s (COO) presentation cleared a lot of the mental blockers I had.

Put simply, the strategy integrates:

  1. Origination: Via its #1 global M&A practice
  2. Investing: Via its 3rd party funds, SMAs, and balance sheet to support alternatives, public, FI, and other investing.
  3. Distribution: Via its marquee wealth management business

Often investment firms today will originate via 3rd party bankers and distribute solely to institutional LPs (vs UHNW / HNW / Others).

Given the rush to both originate investments and distribute them across a broader set of clients in today’s market environment, Goldman has the obvious pieces that competitor investment firms are currently trying to build aggressively (I’m viewing GS as an investment firm today – obviously it can be viewed from the bank angle most other days, but their current growth strategy centers around being a asset and wealth management) .

It’s like they woke up one day and said “Why the fuck is Blackstone worth more than us? Is this a sick joke? Let’s fix this.”

Another firm pursuing a similar strategy, albeit with the pieces currently immature, is B. Riley Financial. Their core is small cap Capital Markets, and around it they are buying / building practices in investment banking and wealth management to bolster their product set but also to complete their ability to originate and distribute effectively.

On origination:

I think a lot of our competitors probably are hindered — not hindered, but are a little bit more focused on just one segment. So let’s just call that the investment banking broker-dealer side. So I don’t know if there’s a lot of comps to us. I mean I would say, there’s firms out there like a KKR ,where they do have a broker-dealer and they do have some advisory and they really utilize that, but the main focus is private equity. We’re kind of the opposite. We really lead with our investment banking broker-dealer, and then we see these proprietary opportunities that we are willing to invest in, and I think that differentiates it.

RILY Q4-2021 Earnings Transcript

On distribution:

Brett, you have understand is that the benefit that [our wealth management business] also has is in — sometimes it creeps to other parts of the businesses. They have been referrals in M&A that goes into Capital Markets. They have been participants in our deals that help our deals get done. So there is another benefit that doesn’t get picked up in the line item of the sub, but it’s a big benefit.

RILY Q1-2022 Earnings Transcript

Alas, I believe this trend is going to reshape the financial services landscape beneath the mega money center banks and set the stage for the next decade of transactions. As for winners and losers, that’s something I’ll leave for someone else to figure out. 😉

Disclosure: I may own shares in companies mentioned. This is not investment advice. Do your own work.

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Melting Ice

A few days ago I finished an interesting book related to the financial meltdown in Iceland.

I really enjoyed it for two reasons. First, people likely understand that on the surface, Iceland blew up in the 2000s with dramatic fashion. However in reality, it was more than just bad corporate governance, there was massive outright fraud. Jared takes the reader through all of it in jaw-dropping detail. Second, broadly speaking it is a showcase of high quality work product on the part of the author, both in the description of how he went though his investigative process despite having no real prior experience, and how he built the seemingly boring SEC-equivalent investigations into interesting pieces of drama for the reader.

I would highly recommend this book to finance nerds as it’s very readable despite the high amount of detail mentioned above. The cultural aspects of a country like Iceland are fascinating, right down to the work culture amid mind bending “hours of sunlight” trends in the country.

What is the takeaway? Perhaps that you don’t have to be a genius to solve difficult problems; diligent, detailed work with original thinking goes a long way.

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Duration Matching is No Cakewalk

Merrill released an updated research piece on Apollo which was insurance focused, and rightly so, given the >60% of earnings that are derived from annuities going forward.

Apollo has argued that its insurance earnings, or “spread earnings”, should trade closer to what more traditional asset management earnings streams trade at:

Respectfully, I don’t think that should be the case. What is missing on the left hand side of the slide are all of the complexities that are bundled with sourcing your capital from an annuity versus a traditional source (drawdown vehicle, REIT, BDC, etc.). It is, in my opinion, precisely why Blackstone won’t touch it with a ten foot pole.

Those complexities boil down to the simple fact that it’s not a cakewalk to “duration match” the assets with the annuity liabilities, and therefore one always has risk on the funding source side in addition to the investment side. The duration of the liability is a moving target, governed by surrenders, crediting rates, minimums, etc. Insurers in the 90s/00s got stuck in the mud within the seemingly “simple spread based insurance” business as rates went to zero and their modeling of lapse rates went out of whack (more people hung around than modeled, extending duration vs projection). Accordingly, they were left holding the bag reinvesting into a low yield world when their liabilities were higher yield.

Complexity increases as the attempted duration match involves “net duration matching,” meaning each liability will have a pile of assets that on a net basis, roughly equal the projected duration of that liability. Apollo’s business has liabilities with an average duration of just under 9 years. An insurance industry insider I chatted with posited that they think Apollo along with the rest of the Alts participating in insurance from an underwriting angle are not duration matching their liabilities when you peel back the onion. It’s not easy to originate assets with duration of 9 years or north of that. 5-7 year duration assets have a much larger pool to fish from. As such it’s possible that these insurers’ “net duration matching” is a bit less simple and secure that they indicate, perhaps including a mix of longer duration and shorter duration assets that don’t effectively always move in lockstep with the duration of the liability.

It further increases when one has to consider that a fixed indexed annuity is also marked up in line with a portion of the S&P500 return (the benchmark may vary), forcing the insurer to own a pile of derivatives to hedge the equity upside risk. While the hedging isn’t rocket science, it does have its own set of variables that change with implied equity volatility. And it is additive to the overall complexity of the insurance earnings stream.

Last, the cash flow of insurance streams is based on statutory releases of capital, which vary based on all the changing variables (and more) that are discussed above. They aren’t as simple as the management fee paid quarterly like clockwork. Real cash flows of insurance businesses are notoriously mismatched with perceived earnings, and for the most part, pushed into the future.

All is to say, to conclude, upon digging it should be clear that the complexity of insurance liabilities as one’s capital source is much, much higher than traditional capital pools (e.g., an endowment writing a check into a limited life vehicle with no ability to early redeem, ever). Asking the market to value this earnings stream closer to traditional asset management not entirely unreasonable, but a stretch. And when a company is going all in on the insurance side of their business versus the traditional side of the house, it may be appropriate to value the overall business at a lower multiple than its peers of the past.

Disclosure: We own shares of Apollo Global. This is not investment advice. Do your own work.

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The Future

Lately, I’ve found the Bloomberg Odd Lots podcast to be a good way to stay upon market trends while on the road. Recently, they interviewed Bridgewater’s Co-CIO Greg Jenson. The podcast made waves by prognosticating a number of things related to interest rates and the valuation of the stock market. It’s a seductive narrative because Bridgewater not only uses a valuation methodology to explain its views, but a breakdown of supply (buyers) and demand (sellers) in the various asset classes he discusses. It’s one thing to believe something will be worth more or less, it’s much more convincing to have a strong hypothesis of which groups will cause a supply / demand imbalance to change pricing.

Here’s one clip from the interview regarding stocks that don’t generate any cash flow and have relied on equity / debt issuance to fund themselves:

Alas, the reason the podcast made the rounds is it simplified the economic system into a pithy explanation that makes the listener think and feel – “Aha! This all makes complete sense. I can get behind this.”

My opinion is, unfortunately, while Greg is not absolutely wrong in what he is saying, he likely speaks so eloquently and simply that the listener tosses out the hardcore fact that the economy is far too complex to simplify and make accurate predictions on. There are likely 25+, maybe 100, legitimate economic inputs whose relative importance vary by the day / month / year. In hindsight, it becomes obvious which few factors drove certain outcomes, but looking forward at the potential performance of a complex and constantly adapting system is somewhat futile to do with any accuracy (and precision).

Personally, I think the way to deal with this massive unknown is to just not play that game. I try, though don’t always succeed, to own assets in which not much has to go right to do “just okay.” Said differently, prices are such that most market participants aren’t excited about the businesses and therefore an incremental buyer isn’t underwriting much in the way of good things happening in the future.

An example is a shopping center we recently committed to investing in. It was underwritten with near zero rent growth, reasonable expense growth (effectively triple-net but there are some expenses), and modest cap rate expansion (the bad way) upon exit. It isn’t a home run investment by any means. It may do roughly an 8% tax advantaged cash return annually. It is a low leverage deal and leverage drops further upon the sale of certain out-parcels (while cash return on remaining equity pushes past 10%). However, what has been unexpectedly happening in outdoor shopping centers is leasing spreads (the difference in rent from the prior lease) have been expanding rather dramatically in select cases. I’ve seen spreads gap out anywhere from high single digits to well north of 20%. Perhaps this center may see spreads expand, perhaps not.

As always, there is no free lunch and every investment, especially equity, comes with risk, it’s just helpful when one can turn off the stress of the future and just focus on the returns of today to sleep well at night.