Author: the_red_deer

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The Folly of Proprietary Deal Flow

Ask any deal maker how they get “good deals” and more often than not, “proprietary deal flow” is one of their referenced sources to get them. What is proprietary deal flow? Most would probably say they have relationships in which they are considered the preferred buyer. A select few will outline more tangible sources of “good deals,” perhaps the scale of their capital base, specialization, geographic focus, etc. I for one, find the term “proprietary deal flow” overused and unhelpful.

In contrast Josh Wolfe, co-founder of deep-technology VC firm Lux Capital, describes his deal flow process differently, and more intellectually honestly. He says that he has no idea where (specifically the source and the topical area) his next great investment may come from but he is certain that his maniacal focus on consuming diverse content, incessant networking, and deep paranoia of not knowing / understanding concepts will lead to his next deal. I suspect most investors actually follow an idea sourcing method more similar to Josh than “proprietary deal flow” being their source of best ideas.

In this vein, yesterday I posted about management fee securitization. I came across it when trying to learn more about the burgeoning GP stakes business. I found it interesting and wanted to learn more about it. In the article I linked to in yesterday’s post, there was mention of a public company investing in GP stakes off its balance sheet called Pacific Current Group. Turns out this company, traded in Australia, has a growing GP stakes business, is trading well below net asset value of its GP stakes, and pays a ~4.5% dividend.

I didn’t strike gold but the point is that I would have never found this if I didn’t just pull the thread of things that interest me. It’s not proprietary deal flow, it’s right there out in the open, but virtually impossible to systematically screen for. To that end, I presume great investors constantly pull the threads that interest them as well as position themselves as fast-moving and differentiated counter-parties. The rest just rely on…proprietary deal flow.

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Management Fees & Securitizations

I’ve been doing some diligence on an interesting private fund that invests in private stakes of alternative asset managers. In that research I was shocked to find out that GP stakes managers have securitized and sold interests in management fee streams of private funds in the recent-ish past:

Source

It doesn’t seem odd in retrospect as I personally believe and invest behind the idea that PE shops’ fee streams are fundamentally under-appreciated by the broader market but I hadn’t thought of this concept on my own.

It also somewhat aligns with the idea that PE firms noticed that the public equity market likes management fee streams by virtue of the high multiples it places on it, in contrast to the fee streams associated with carry. Compensation of PE professionals (on the opportunistic side of the spectrum where carry is substantial) is now moving towards heavier weighting of carry vs fee streams as the employees value the carry more than the fee streams (opposite to the public market).

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Patria Investments 2022 Outlook

Yesterday I took a bit of time to review what Patria Investments, a LatAm focused alternative investment manager listed on Nasdaq, guided for 2022 on their Q3-21 earnings call. It made me want to review what my variant views on the business are – or said more simply, why do I own it.

Here are my thoughts:

  • LatAm, especially Brazil, favors local investors / knowledge as multi-nationals have failed repeatedly in these relatively closed economies, which supports longer runway for alpha generation than market believes.
  • Patria has and will continue to lay groundwork to emulate the Blackstone playbook with respect to product buildout across credit <> equity and perpetual core <> opportunistic drawdown spectrums, driving potential TAM expansion and acceleration of growth
  • Patria’s low current wallet share of global mega LPs enables rapid AUM growth as investment capacity increases
  • The alternative asset manager business model (both FRE and Carry) is more durable and predictable than the market believes, and the market offers them up at reasonable prices as a result

Current valuation is not dirt cheap, it trades for ~20x 2022 FRE1. Add in $0.30 / share for carry2 gets me to ~$1.10 / share in DE or ~15x DE.

15x is a fairly reasonable price so long as the company grows in the 15% range, and that does not include the ~$200m sitting on the balance sheet earmarked for M&A (another potential $0.15 / yr3 in DE). It’s cheap if it continues performing at the ~25% FRE growth that it has been performing at in recent past.

Based on the setup I described above, I think the business is well positioned to grow at a reasonable rate over the medium term with little business complexity, no debt, high insider ownership, and well-supported shareholder dividends. It may also offer reasonable shareholder returns as a result.

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

1 – $75M in ’21 FRE, 50% growth for ’22, 140m shares, $16.5 / share

2- Current accrued carry is ~$315m, and if you assume they monetize over 5 years, that’s another ~$41m (35% of carry paid as bonus to employees)

3- $200m invested at 10x DE, based on guidance for future transactions and prior Moneda credit platform transaction (Q3-2021 earnings call)

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Coping with the Future (and our inability to know it)

Yesterday (or perhaps late in the prior day), the ECB joined the Federal Reserve in signaling a change in policy towards fiscal tightening, specifically going backwards on its prior multi-year regime of supplying low rates and plenty of liquidity to support the global economy through the pandemic (the UK central bank also raised rates yesterday).

The million dollar question in the near term is – will a rising rate environment paired with monetary tightening (suspension of open market government bond purchasing) hurt the economy but tame inflation, help the economy and tame inflation, or hurt the economy and not tame inflation. Every tends to think about the outcome with respect to what their “book” is.

One investor group, VCs and Growth investors, talk of a central bank induced recession on the horizon. Why? In part, because the companies they own are valued (or were valued one quarter ago) at rich valuations. When rates go up, valuations decline, but rich valuations decline far more than cheap valuations broadly speaking. Simplistically, if rates go up 1% and a company traded at a 1% earnings yield (100x earnings), the valuation of the company would drop by 50% if it traded at a 2% earnings yield. If rates go up by 1% and a company trades at a 20% earnings yield (5x earnings), the valuation of the company would drop by 5% if it traded at a 21% earnings yield.

Of course, there are examples across the spectrum ending with constituents that cheer rate increases and do not believe it’s possible to have a recession given how strong the consumer, unemployment, and other core data are looking.

To that end, the reality is the vast majority of constituents across the opinion spectrum don’t truly know what will happen, chiefly because the world is a complex adaptive system that constantly evolves / morphs as inputs change. It’s not a machine that has predictable outputs with the same inputs.

The best medicine for this is understand how one’s current situation is positioned for all outcomes and avoid the worst potential spots, which in this case I believe are assets that are (1) speculative beneficiaries of high liquidity or (2) highly valued or (3) very sensitive to consumer demand.

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Public Markets – Feature or Flaw?

A few short data points before discussion.

Yesterday, one of the largest companies in the world by market value dumped ~$200B+:

Furthermore, Snap, had an unbelievable whipsaw in the same day due to blowback from FB and a positive earnings release post-close:

While movements like this tend to prompt the crowd to skewer the efficient market hypothesis in the short run, it does resurface a number of questions for the individual investor:

  • Is the occasional wild swings in publicly marked enterprise value a feature or a bug?
  • Does a public markets investor have adequate information to make high-ish probability wagers on the enterprise value of the company?
  • Are most public markets participants suited to participate in the venue?

Of course, I have thoughts on each, and there are no right answers. But they pertain to the marriage of my personality to the characteristics of public markets (both features and flaws). Your personality may merit a different set of answers.

That said, on a daily basis via Twitter, I see countless investors’ thoughts and actions provide strong implied answers to the above questions. Especially on days when the above swings in market values are extreme. Most often – investors:

  • Take price momentum as a directional indication of the quality of corporate strategy
  • Believe that their insight based on analysis of publicly available data is equal or better to the broader marketplace
  • Lack conviction when fundamentals and public marks aren’t going “up and to the right.”

Mind you, these investors I am referring to often include fiduciaries, fund managers, analysts, etc. The natural question of the reader is, does this author believe he is above the crowd and master of the universe?

No. As I laid out in a prior musing, I don’t invest (for the most part) in “businesses” explicitly. I invest in broad mandates with an investor at the helm. I’m an LP. Why? Specifically I believe that I fail the second bullet point / question I posed. But that’s okay. I carved out my niche and love the vantage point by which I can spectate and participate. The question, reader, is have you taken the introspective time to figure out what your niche truly is?

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Provenance Updates

I don’t really participate in the “crypto” ecosystem beyond keeping tabs on one project. My general thesis on the overall space is that there will be blockchain use cases that definitely improve certain legacy workflows by 10x or more by virtue of the feature of stamping information to a public ledger. The use cases that Figure (and the open source Layer 1 protocol it developed, Provenance) align with where I’m comfortable (financial services) and excited to see where it goes.

Yesterday, the developer team answered a bunch of elementary questions for an outsider and I was happy to lurk and learn.

On the path of starting with high market cap (~$10B today despite being virtually unknown) and high insider ownership, then driving that down over time:

On how Provenance visibility may change in the near future:

On 2019 Provenance vs 2022 Provenance:

I’ll be watching from the sidelines. I bought a small amount of Hash, the token associated with Provenance, mostly to learn more about digital assets, to learn about staking coins to earn yield, and to have a tiny bit of skin in the game. By staying somewhat wired into an ecosystem like this, I presume that in the course of my life, there will be opportunities to buy digital assets at “value prices” with juicy real yields behind them. I’ll be ready to back the truck up when that time comes, if ever.

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Keeping It Simple

One of the tenets floating around my brain that gets amplified further as each year passes is: Don’t play against the best in the investing game, figure out how to ride behind them.

Few hear about the cyclists supporting the main star, the lineman supporting the quarterback, etc. In some sense, LPs support start GPs by providing the raw material to their process: capital.

I’ve been somewhat privy to the investment process of marquee investment funds as a “strategy consultant” performing commercial due diligence. Patrick OS had a saying for some of his early guests on his podcast “Invest Like the Best.” It was “This is What You’re Up Against.” That paired with my prior window into underwriting has always stuck with me.

Investments I’ve made into companies with narrow mandates (e.g., sell or focus on one narrow product area, say something like Peloton, which I haven’t owned but describes what I stay away from broadly speaking) have tended to not go well. Core reason being I lack conviction to hold them. The reason for lacking conviction is not truly understanding what I own, and depending on management’s words to define the variant view.

Investments that have gone very well tend to be “things” with broad mandates. Publicly traded private equity funds, diversified debt funds, public investment holding companies. Essentially when I remove myself from the underwriting seat of investing in narrow mandate investments and just focus on paying a reasonable price for an investor with a broad mandate, things tend to go alright.

To that end, Brookfield Infrastructure Partners (BIP) has been a longtime holding of mine. It’s a publicly traded private equity fund focused on infrastructure – and has a great management team that a strong track record in their process of acquisitions and divestitures. At times it gets expensive and rarely it gets cheap-ish. That said the long-term holder has done well:

I look forward to continue holding units in this entity for a long period of time.

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Steak + Sizzle

People like to use the above phrase to describe investment opportunities that offer a solid core business and potential upside options associated with the business.

In this case, I’m thinking about Westinghouse, a portfolio company of Brookfield Business Partners (BBU) that I’ve owned for a while and recently increased to be a full sized core position.

Brookfield’s PE business bought this business out of bankruptcy as a sort of “value” investment – in the sense that it was a low statistical going in multiple. The team was able to execute on their underwritten cost reductions and has been tucking in a number of smaller acquisitions to grow its service and coverage.

The investment has been a smashing success, as the business is throwing off 30% cash on cash at this point. To that end Brookfield bought the steak cheaply.

Westinghouse is a nuclear services business with ~50% market share. Nuclear power has historically been a shrinking market based on the perception of nuclear disasters. What is interesting about the business is in light of a few things, not limited to but including energy crises in the EU due to renewables not successfully filling the gap during cold spells, increasing (and persistently volatile) hydrocarbon prices, and decreasing geopolitical stability, nuclear is having somewhat of revival in perception.

If the turn in perception results in true change in action, specifically in deploying more nuclear vs. shrinking the supply, the single digit organic growth of Westinghouse may change dramatically. Furthermore the multiple of the business would dramatically change. The proverbial sizzle.

Edit: Bloomberg had a timely article on the state of EU nuclear in today’s news.

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Opportunity Down Under?

Back in July, Apollo announced that it was in agreement to acquire a total of ~18% of Challenger. I believe ~15% was a direct transaction with a prior shareholder and the balance was acquired on the open market. While I’m not 100% sure how to think about the diluted share count with the converts / sub debt in place, Apollo paid ~$6AUD / share on an undiluted basis. Book value is ~$5.70 AUD / undiluted share.

Challenger is a top retirement services provider in Australia, much like Athene is in the US. They are just north of $100B in AUM and per Apollo, have a decent asset origination platform to invest their annuity / life insurance liabilities. It has reach into Japan, a market Apollo is supposedly spending a material amount of time on given what its belief of the Japanese TAM is.

Challenger seems to be targeting a 12% ROE with a permanent surplus capital position for rainy days, with recent (’21) performance around 11%. In comparison, Athene does 15% with a substantial excess capital position. Perhaps therein lies the opportunity (Challenger’s CEO of multiple decades is retiring in March as well).

In any case, Challenger aims to pay out 40-50% of its earnings in dividends. The ’21 calendar year was ~$0.20/share with prior non-covid years around ~$0.35/ share, or roughly 3.5% and 6% dividend yields respectively on the current share price. The company is guiding towards full earnings power / 12% ROE in ’22 so at book value one would expect a 6% yield going forward.

Perhaps more interesting to think about is the question of whether Apollo will buy out Challenger. Is Apollo trying to increase its “Spread Related Earnings?” They haven’t been specific on SRE growth – but Marc Rowan has said in the past that they want to make as much money on any single asset that is originated – and making money on both the asset management fee as well as the spread between earnings and liability payouts is the way he accomplishes that (or asset management fee + “ADIP” fee).

I personally think it’s likely that Apollo consumes Athora, its European retirement serves arm that it has a minority stake in today, as well as other international platforms. Challenger is a clear candidate in my mind but only if they can purchase it for book value. And now it’s at book value. Maybe they bid if it hangs around this price or lower for an extended period of time (e.g., 6+ months).

In any case, food for thought.

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Trimming the Fat

Weekends are a good time to take stock of everything that I’ve put into my brain during the week. I’ve been chewing on a couple things: how much cash I should be holding, trimming certain non-core positions, and whether to add more ordinary income / Yield investments.

Come Monday I’ll be trimming a small position that has no distribution to reallocate to other opportunities. My process isn’t perfect. While I think the position on the way out has merit and is low risk – it doesn’t fit in my underwriting box. I can tell because (1) not paying distributions is explicitly something that goes against the primary goal of building further investment income and (2) in my gut it doesn’t feel high conviction despite the very low risk nature of the investment.