Author: the_red_deer

I typed this up yesterday for somebody I was messaging with via Twitter regarding Apollo’s annuity earnings (or Spread Related Earnings, as APO calls it). Not spell checked or edited – just a quick note, but wanted to record it here for my own reference in the future. The question discussed was what is an appropriate multiple for the spread related earnings business:

The annuities business model, separate from how multi-line insurers work, is really a pile of other people’s money, with a guaranteed return that is similar to AA bonds (over-simplifying). Insurers invest that money for the most part in investment grade, so BBB and higher, debt. Something like 95%. 5% can be invested in equity.

So it’s not too dissimilar from banks, or the old GE capital – it’s just that the funding source is locked in with roughly a 7-9 year duration, all things equal. Other funding bases can be deposits, short term credit, etc. So I think the annuities business gets a plus in that it’s more permanent capital than others’ funding bases and are far better duration matched than other levered finance business models. The minus is APO’s funding source is more complex. Surrender rates, options hedging, minimum guaranteed returns, etc. But APO / KKR would argue that these are highly manageable.

On the asset side, not too dissimilar from banks, they are trying to make investment grade loans, either public or private. They are definitely exposed to the credit cycle, but the question is how much. Do they do better, the same, or worse than comparable levered finance vehicles. The sponsors will tell you they are taking excess spread with the same or less risk. Covid wasn’t a good test, things came back before they really blew. ‘18 wasn’t a good test, and Athene / General Atlantic were born out of the credit crisis. 

Furthermore, is the business just effectively a loan book or has actual franchise value? How much are they actually originating themselves or is this just a chop shop for old blocks? I think recurring earnings should make a difference on the perceived quality of earnings.

I think similar levered finance vehicles are a good starting point. Comparable sized banks maybe trade for high single digit to low teens P/E. Other fixed annuity providers trade around book value, which is roughly high single digit P/E with low teens ROE.

Stepping aside, the question APO asks is what do you value a business that is growing at 15%+ with relatively “predictable” revenue streams, with 15%+ ROE, that is the largest in the industry by far, etc. Rowan thought that 6x earnings is too cheap and therefore bought Athene. I think he wouldn’t sell this business for 15x. I think that he believes that it should trade at 20x+ but I personally don’t think it ever will, because ultimately you need to trust what’s inside the black box. In the 2000s people didn’t care what was inside the black box and you got to 20-30x earnings. Think that’s a bad way to calibrate and once there is another credit cycle, if it is proven to be a low loss loan book, it gets closer to 15x than the single digits it trades at today.

One has to remember that the entire industry of insurance has been a tough one over time. JXN trades for a low single digit P/E with variable annuities. Brutal. Overall, as an investment, I think the SRE earnings streams in the fixed annuities space likely should trade higher than what APO and others acquired them for, but that’s because I also believe that they are good investors. If that’s not right in the next credit downturn, then they aren’t worth more than book, etc. So for me, I’m happy to own it at the current implied multiple and if the sponsor proves it out, it’s upside, but I’m not really paying for it, nor do I expect returns from a re-rate.

Disclosure: I own shares in APO, this isn’t investment advice. Do your own work.

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.