I’ve written over 10 pages in the past two weeks and discarded them all. Sometimes, things just don’t click, and I find it better to start over than to finish a concept that doesn’t hit the mark. However, there’s a fine line between that and paralysis. Today is the day to get some words on the page to break the cycle.
While rain is nothing new in Seattle, it can take many by surprise in other places. Not checking the weather and being unprepared with an umbrella can ruin an otherwise survivable day. The same approach tends to apply in capital markets. When fear grips pricing, homework must have already been done. Learning about businesses when liquidity is falling apart is a challenging endeavor, similar to shopping for an umbrella at the beginning of a strong rainstorm.
Knowing one’s psychology is also crucial to understanding whether to duck into a restaurant and have a meal to wait it out or brave the storm to reach the next destination. In his book, Steve Schwartzman outlined this point:
The best time to buy is when there’s blood in the streets. That’s when you get bargains. But it’s also when you have to be most careful. You don’t want to catch a falling knife. You want to wait until it hits the floor and bounces back up a bit.
What It Takes: Chapter 16 (Why There Are No Old Brave People In Finance)
Others take a different approach and “catch the proverbial knife” by buying on the way down.
As financials took a beating over the past few days, unlike in the past when I was unprepared, this time I had a name in mind that I wanted to own but was waiting for the right price. OneMain Holdings is a market-leading sub-prime consumer lender with a 20% share of the installment lending market. It’s a sandwich of AIG and Citigroup’s legacy subprime consumer lending businesses, shepherded by Fortress in the prior decade. In essence, it is similar to a bank in that it borrows money and lends it out. However, its borrowings come from long-term fixed-rate bonds and medium-term fixed-rate securitized debt, not deposits.
In some sense, it is constructed inversely to the regional banks feeling pain this week by having longer duration liabilities than assets when one considers the unsecured bond liabilities and non-recourse match funding on the securitized funding side (there is nuance, but keeping it simple).
It runs a highly efficient operation, with low operating costs, charge-off rates, and high cash generation. It currently trades for a market cap of $4.3B with total adjusted capital of $3.2B. It generally underwrites to a 20-30% return on total adjusted capital or $0.8-1.2B annually. It returns about $500M to shareholders via dividend and returns incremental earnings to shareholders via repurchase (~$280M last year but likely much lower this year). More importantly, as a banking business, the company prioritizes discipline and consistency over growth. Here’s what the CEO had to say:
We try to stay disciplined and stick with our discipline. I’ve talked before about we actually don’t manage the growth. Growth is an output. We have our credit box. It’s very specific and granular. We want to put customers in loans, they can afford and pay us back. That’s good business for our customers. It’s a good business for us.
Barclays Financial Conference, September 2022
Bigger picture, the major questions I ask myself about this business are whether consumer credit will grow or shrink over the next 5 years and whether unemployment will rise to deeply recessionary levels (say 8-10%)? Both questions I am unqualified to answer, but willing to bear the downside risks given diversified portfolio construction.
As Schwartzman outlined what works for his psychology, deep concentration in home-run like ideas doesn’t match my personality. I tend to find greater confidence and comfort in a diversified portfolio with a material yield to anchor on. To each their own. I bought a small amount of shares, specifically roughly 1/15th the largest concentration I would take in a new single stock (which is roughly 3%). But as the portfolio is designed for yield, not market timing, with each month that passes with the pricing being acceptable, I’ll be able to grab a bit more.
I like listening to Bob Prince of Bridgewater when shows his face a few times a year. He released a note about a month ago that I just caught up on. The title of the note is “The Tightening Cycle Is Approaching Stage 3: Guideposts We’re Watching” – and the takeaway on his crystal ball is below:
To get 2% inflation, you need a deceleration in wage growth from the prior 5% to about 2.5%.
To reduce wage inflation, you need to cut nominal spending and income growth in half to 3-5% and raise the unemployment rate by 2% or more.
To raise the unemployment rate, you need to drive nominal GDP growth materially below wage growth and compress profit margins enough to produce about a 20% decline in earnings.
After that, you need to hold short-term interest rates steady for about 18 months, until 2.5% wage growth, 2% inflation, and 2% real growth are sustainably achieved.
Then cut short-term interest rates to about 1% below then-existing bond yields.
So are we on track or not? Below, we scan through some of the guideposts we are looking at to assess where we are in the tightening cycle.
As for what to do about it, one can debate macro implications on portfolio construction until blue in the face. Or one can just follow the below IQ meme (h/t @marhelmdata), which is what I prefer.
Buffett is godlike in the investing world. Despite being a generally lackluster human being on a personal level, people love him so much. People who hate him always qualify their statements with “let’s be clear, he is the greatest of all time, but…”
Cliff Asness recently appeared on one of The Economist’s podcasts, discussing his incredible 2022. However, it should be noted that Cliff, a billionaire, can be thin-skinned and overly sensitive. He responded to one of my tweets (from an anonymous, small Twitter account) that was not directed at him in any way with a dismissive and snarky reply, and promptly blocked me. What’s the old saying? Never meet your heroes? I digress.
Cliff’s firm puts out generally interesting research that cuts from a different angle than the usual value drivel on “intrinsic value” that I come across. One of the more interesting papers is titled “Buffett’s Alpha,” which was done by his AQR co-founders. In a nutshell, the researchers found that Buffett’s outperformance can be explained by a number of simple investment factors amplified by leverage. In their words:
In essence, we find that the secret to Buffett’s success is his preference for cheap, safe, high-quality stocks combined with his consistent use of leverage to magnify returns while surviving the inevitable large absolute and relative drawdowns this entails. Indeed, we find that stocks with the characteristics favored by Buffett have done well in general, that Buffett applies about 1.6-to-1 leverage financed partly using insurance float with a low financing rate, and that leveraging safe stocks can largely explain Buffett’s performance.
However, the paper indicates that such a strategy suffers from brutal drawdowns that most people would not survive.
Berkshire has had a number of down years and drawdown periods. For example, from June 30, 1998, to February 29, 2000, Berkshire lost 44% of its market value while the overall stock market gained 32%. While many fund managers might have had trouble surviving such a shortfall of 76%, Buffett’s impeccable reputation and unique structure as a corporation allowed him to stay the course and rebound as the internet bubble burst.
In conclusion, Buffett’s prowess is undeniable but…(see what I did there?), often quoted investing wisdom derived from Buffett including concentrating funds in best ideas, holding wads of excess cash, and being greedy when others are fearful may be missing underlying factor(s) of his investment success.
Housekeeping:I will be increasing the amount of posting I do, and if you are a subscriber, you should expect the quality of writing to go down. I went the other way more recently, writing longer form, meatier thought pieces. I have enjoyed it and it certainly is more rewarding than half baked writing. That said, I don’t have that many interesting thought concepts brewing in my mind at all times, and waiting for interesting topics to coalesce comes at the expense of regular practice in writing, which I value. As such, feel free to cut and run as your inbox fills up, no skin off my back.
Glencore has been in the news lately, reporting outstanding results for 2022, thanks to peak cycle performance from its coal unit. Going back in time, Glencore (previously known as Marc Rich + Co) was primarily known as a commodity trader. It operates in the gray area of global commerce, connecting counterparties that its white-shoe competitors can’t touch and earning mouth-watering arbitrage spreads. Today, it appears more like a global commodity miner with a commodity unit attached. However, its swashbuckling commodity trader aura and culture still loom over its current operations, casting a shadow over the company.
Not long ago, in 2015, Glencore was struggling. This is not uncommon for highly leveraged firms, as cycles bottom out and expose the naked to all. However, Glencore made it through, and the scars show. The company has taken a more responsible capital allocation approach and, in its most recent performance report, boasted a net debt level effectively at zero. Bloomberg has quickly put out a piece on what’s next, now that Glencore’s capacity to fund massive growth projects is deep and primed.
But what does Glencore mean to me? Although I’ve admired commodity traders since my days as a commodity derivatives market maker, the sovereign nation penalties that can be imposed on such a business if they cross the wrong politicians can be significant. Make no mistake; while Glencore and its competitors speak today of net zero, ESG, etc., their bread and butter is doing business where others can’t, whether it is trading or mining. Fines by federal agencies across the world are merely part of day-to-day business at this type of company, and criminal charges are not unheard of. It always seemed like too many left-tail risks for the price.
However, here we are today, with the towering executive Ivan Glasenberg, the original Glencore guard and architect of its transition to mining, having moved aside. The company is positioning itself as a run-off coal miner and producer of green technology inputs for the future. Its debt is now zero. De-globalization and the rise of developing countries benefit its business directly. It holds significant positions in global production across important commodities, namely copper.
In the past bumper year, Glencore self-reported $24 billion in free cash flow. Its enterprise value (market capitalization) is approximately $75 billion. Despite 50% lower coal prices, it has guided to a more normalized $10 billion in free cash flow for 2023. Cash returns to shareholders for 2023 may range in the $3-4B zip code, as Glencore has a variable dividend policy, pegging a 2023 dividend yield at somewhere between 4-5%.
All in all, while in the past, I was hesitant to delve deeper into Glencore, I think it may make a nice addition to a diversified portfolio approach. Natural resource spot exposure from a firm with some characteristics of offensive tendencies during economic downturns that pays cash back to shareholders is nice. However, cash returns are too low for me given alternative options in the market today, but for now, this one stays on my radar.
Much ink has been spilled amid the drama of Blackstone’s BREIT outflows. The long story short is that BREIT (along with other non-traded vehicles) has powered Blackstone’s fee earnings over the past 3 years by promising investors stable yields and total returns by shoveling money into real estate’s hottest sectors (multifamily, industrial, etc.). It worked for a while, until public markets dumped in 2022, and comparable publicly traded real estate vehicles traded down 20%+ while BREIT curiously posted positive returns. Investors balked, and withdrawals started.
I like the legacy alternative asset manager business model a lot, mostly because it is a high return on equity business, requires little or no leverage, trades relatively inexpensively, and most importantly, has benefited during times of duress in the past. Alternative asset managers are one of the few business participants that have the ability to invest large amounts of money at the bottom of a cycle without having to explicitly overcapitalize their balance sheet (reducing returns to equity) during good times. This is because their customer base and funding base have largely been gigantic institutional LPs. These LPs have a constant stream of incoming cash to invest with less sensitivity to prevailing market conditions. And they are willing to agree to contractual commitments to fund capital calls even if market conditions materially deteriorate from when the contract is signed.
It is really powerful to have long-duration capital when capital has disappeared from the market. And growth into the non-traded REIT/BDC market trades that feature of its institutional LP base for the opposite among retail HNW investors. Thus if you follow me on Twitter, you’ll know that I’ve been negative about Blackstone’s business model quality for some time.
HNW investors, for the most part, react similarly to small-ticket retail investors. That is, they deploy the most capital at the top and generally withdraw it at the bottom. As an asset manager, that makes one’s business pro-cyclical vs. more all-weather.
Public companies exist to grow earnings. Today, companies that have limited growth runways and are solidly in the “cash cow” portion of their lifecycle get little love in the public markets. The implication is that companies are incentivized by investor preferences for growth to chase growth. In the case of asset managers, Blackstone and its public competitors have taken the red pill of growth in HNW channels, diluting their somewhat all-weather institutional funding base. During good times, the results have been nothing short of dramatic. However, given today’s market turbulence and uncertainty, the negative implications are on full display, with management playing firefighter to a barrage of negative press.
Other asset managers have taken different approaches in the past to mitigate the liquidity vacuum created by HNW investors during bad times. For well over a decade, Brookfield has used publicly traded vehicles to access the retail market. One can purchase a slice of its private equity, climate transition, renewable energy, or infrastructure funds with the click of a button. And by and large, it has worked well when the public narrative for the specific sector is positive. However, where the narrative is negative, Brookfield takes the public stock egging that many argue Blackstone’s BREIT is not showing up for but deserves.
Take Brookfield’s private equity vehicle as an example (Brookfield Business Partners). It holds classic PE targets, namely companies with low revenue volatility, modest growth, and high cash generation, which support strong amounts of leverage. Today, the vehicle trades at a nearly 50% discount to Brookfield’s estimated break-up value.While I’m not here to argue Brookfield’s assertions, they illuminate the discrepancy between the manager’s opinion of value and that of the public market. I’m inclined to believe that the private LPs invested in Brookfield’s private equity portfolio are receiving quarterly marks that do not match the publicly traded sleeve of the vehicle.
Furthermore, take Brookfield’s former publicly traded real estate vehicle as another example. It owned a large number of premier office buildings and purchased the second largest mall company in the United States. Both sectors sport narratives that have been highly out of favor with both retail and institutional investors for years now. Accordingly, the stock traded at a persistent discount to Brookfield’s estimation of NAV, and Brookfield ultimately used its balance sheet to take the vehicle private. No doubt, this outcome was a failure of its retail vehicle due to the difficulty in selling an attractive narrative in offices and malls (among other serious issues with the vehicle).
While most of my thoughts regarding pursuing HNW are largely negative, it doesn’t have to be all bad. At the end of the day, investing is about matching unique opportunities for excess returns with the right amount of capital. BREIT seemingly set an unlimited budget for investor inflows and entity size, reducing the “intellectual edge” of the fund (or alpha capabilities) to sub-industry beta selection (multifamily, industrial, etc.) versus a real estate index.
BREIT Website
Brookfield’s now private real estate vehicle was similarly an office and mall sub-industry beta play. Is it possible for a non-traded vehicle to be a truly unique vehicle predicated on contrarianism, opportunism, or complexity (read: an alpha vehicle)? I think yes, but it must be size constrained to match a presumed consistent set of alpha opportunities—a strategy that is inherently capital-limited and does not support dramatic asset manager growth. Unfortunately, there is far more growth potential in sub-market beta selection, because of its ability to absorb massive amounts of investor capital.
This commentary ultimately aims to make the point that alternative asset managers have started or are well down the path of trading their advantage, all-weather funding, for the growth and fee potential of a pro-cyclical funding base. While I have primarily mentioned Blackstone, virtually every alternative asset manager is pursuing or has pursued copycat vehicles. Furthermore, these alternative asset managers consistently outline a low retail wallet share as a future opportunity. Looking forward 10+ years, if alternative asset managers succeed in penetrating this large “market opportunity,” one has to be aware of the change in funding base and thus style drift (towards universally attractive narratives that can absorb massive amounts of beta capital), which ultimately may result in lower business quality.
They may make today’s alternative asset managers look slightly more similar to today’s mutual fund companies, the black sheep of the finance industry, versus the barbarians at the gate of the past.
2022 was a landmark year in markets, driven in large part by the reversal of a decade-plus regime of low interest rates and low inflation.
As I look toward 2023, my general outlook is that there is no obvious positioning for success, given the wide band of potential actions and outcomes. This is especially true for a tax-sensitive investor, as tax-exempt investors can construct a credit portfolio that locks in a high single-digit return over the medium term.
The view I generally share is that inflation has likely peaked, but it will be a long and tough road to get from 4% to the target of 2%. Many structural forces are causing resistance, including but not limited to de-globalization, unfavorable demographic trends for labor, and ESG-driven misallocation of resources.
Below are thoughts across the asset spectrum specific to what I find interesting, not all possible assets.
High Grade Credit
(Note: I used blunt force to tax adjust pre-tax YTM at 63% of gross YTM.)
Near-term government credit continues to provide good returns relative to the risk taken. The 13-week Treasury bill yields 4.34% as I write this. At the top federal tax bracket, this gets reduced to 2.73%. While exciting compared to the near zero of years past, the inflation factor throws cold water on this post-tax return.
Structured products continue to provide a 150–200 bps yield boost to comparably rated credits. AAA-rated CLO products (e.g., JAAA or CLOI ETFs) are earning roughly 200 basis points over SOFR, which currently stands at 4.32%, resulting in an all-in yield of 6.25%+. Tax adjustments for the top tax bracket result in a roughly 4% yield.
Muni products are most often fixed rates, and as of this writing, they yield roughly 2.6% for short duration and 3.75% for long duration exposure (both tax-exempt). One may consider munis vs. floating-rate CLO debt if locking in a rate is interesting vs. being exposed to the Fed lowering rates in the future with floating-rate credit.
Low Investment Grade and High Yield
BBB-rated CLO securities (e.g., JBBB ETF) currently yield about 525 bps over SOFR, or 9.5% (6% post-tax at the highest bracket). Remember, BBB-rated CLOs have a cumulative loss rate of 0.3% from 1995 to 2019 and sit behind roughly 15% of the capital stack in the form of BB-rated debt and unrated equity.
In the high yield arena, high yield bonds yield roughly 8.5% on a hold to maturity basis or 6.5% on a current yield basis (at an average price of 87). If yields rise significantly, high-yield bonds will fall, but bankruptcy recovery value will act as a lower bound on pricing.Thus, high-yield bond spreads to treasuries may not gap out as wide as in the past given the low coupon at issuance and the dramatically higher rate environment today. It is notable that high-yield bonds tend to be BB-rated vs. B-rated in the past, whereas leveraged loans have migrated to being mostly B-rated vs. BB-rated in the past. High-yield bonds can be interesting because they offer duration, high yield exposure, and a higher average rating than leveraged loans.
Leveraged loans yield roughly 8.9% and trade for roughly 93. These loans’ interest rates continue to rise as the Fed raises rates, a double-edged sword.While near-term income is higher, it is to be determined how many companies default as a result of the higher interest costs. My personal view is that the current pace of the proliferation of stress is slow, and stress that is well telegraphed often doesn’t cause proverbial “heart attacks” in markets. Given the current rate of income and average price of leveraged loans, it will take an acute rise in defaults at 2-3x the average high yield default rate to start driving losses.
Add in roughly 150 to 200 basis points for an illiquidity premium in direct lending, and you can get to just over 10%. Furthermore, certain direct lenders have leveraged their balance sheets (via BDC structure) with a handful of fixed-rate debt during good times, driving leveraged yields to the mid-teens before fees.
While equity returns on leveraged loans can appear interesting, it is worthy to note that at the highest tax bracket, leveraged loans get cut down to roughly 5.7% or 8.8% in a BDC vehicle. a material deflation of yield for the risk taken.
Equities
As a dividend-focused investor, I continue to find alternative investment firms interesting, with many yielding around 7% with qualified tax treatment. The contractual nature of their private fund vehicles places some form of floor on revenue degradation in the current macro environment. Furthermore, top-tier credit-focused asset managers have benefited from funding lines being reduced to lower-quality lenders, and banks have effectively shut down the high-yield market. In short, a great environment despite the material decline in the equity prices of these companies
I also find financials in general across large-cap banks and non-bank financial institutions to be interesting. Post-GFC, most live in a permanent penalty box imposed by regulators or investors and dutifully return fistfuls of capital to investors while keeping excess capital versus prior cycles. Again, while this market continues to absorb a known sickness versus a sudden, unforeseen terminal event, these sorts of financials should be able to absorb material amounts of increased future losses.
Last, certain publicly traded private asset funds with modest yields (4-5%) sourced from infrastructure earnings are trading down to levels that appear interesting, given diversification, stickiness, inflation indexation of contracts, and very long duration debt structures.
Conclusion
In a world in which rates may need to stay elevated for the medium term, the key question is where unforseen potholes will emerge. It is a certainty that corporate defaults will rise. But in light of rates taking time to filter through to the economy, everyone has had fair warning across the constituent spectrum, and I don’t believe defaults get unhinged like many predict.
It is clear that unemployment will rise, but in light of extremely tight labor availability paired with depressed immigration and a boomer labor force that in part turned off post-Covid, I don’t believe the unemployment rate will spike as it did during the GFC given current rate path guidance.
Overall there is a general abundance of assets that trade at prices that are attractive absent the unexpected (a geopolitical event, a natural disaster, etc.).
If you follow Apollo casually or closely, you’ve no doubt heard the banging of the “origination engine” drum. Well, I believe Apollo’s latest deal to acquire some of the assets and team associated with Credit Suisse’s Securitized Products Group (SPG) may be a bigger deal than current information lets on.
Why? A few points to make on SPG:
It is really good at what it does.
It’s likely to be really big.
Platform Quality
Apollo signed a definitive agreement to pick up a portion of CS’ notable Securitized Products Group this week. While all I have to add is speculation, since it likely won’t be reported on by Apollo until the GS financial services conference in December, or potentially Q1 earnings given the moving pieces, I figured it might be helpful to put some thoughts down on paper.
First, what is known: The SPG group is, or was at least, a marquee group at Credit Suisse. It was ranked #1 in all US securitizations, including RMBS, pass-throughs, and agency CMBS in 2018. It participates in the consumer, commercial, residential, commercial RE, transportation, renewables, and “other” alternatives buckets. Basically, the full gamut of the ABS landscape.
Within SPG, it is important to know that the business is made up of:
Origination
Distribution
Market making
Obviously, Market Making does not qualify as a piece of the business that Apollo will pick up, as it is in the business of longer-duration fee streams that have lower volatility than a trading business (which is inherently deeply episodic). So it is likely that Apollo is picking up the entirety of the Origination business and perhaps some or all of the distribution business (which it can fold into ACS).
But more notably, Market Making made up roughly 1/3 (or perhaps more) of the revenue stream. There has also been a whisper that SPG printed north of $1B in profits during bumper years. One can presume these bumper years were driven by the Market Making group capturing outsized spreads during volatile times. Alas, the fee-based (and balance sheet) origination business was likely less volatile, though a growing portion of SPG’s focus.
There are numerous mentions of how the group was a star in the portfolio. Its actions are emblematic in many ways of Apollo’s culture of distress investing. Here are views of SPG’s participation in the liquidation of AIG and Fannie’s toxic asset pools:
Credit Suisse often commented on SPG specifically on earnings calls:
“I think it’s fair to say, and I actually said this on the Newswire call this morning, that the trading environment, which we had in the first quarter a year ago, was extremely favorable for the mix of businesses we have, particularly around securitized products…”
“Securitized products continue to outperform, especially in our #1 ranked asset finance franchise and non-agency trading businesses.”
“Jay Kim, who runs the team, is spending more and more of his time in Asia. And there is a huge upside there. If you think about what [securitized products] has done for us in the U.S., you can imagine in Asia.”CS Transcripts
Alas, I personally believe that the trail of evidence indicates that this was a good business. However, notable leads have left over the past years, and while Jay Kim (the current leader) has been part of the group since 2012, it is to be seen how solid the group is in its current form.
Might be a Beast…
For the sake of argument, let’s use MidCap’s rough figures to guide our calculations. MidCap does roughly a 13% ROE (normal times) and is leveraged 4:1. If SPG made ~$1B in good years, let’s say that the origination engine pumped out ~$500M of that (50% market making share to be safe). And let’s say the business generates a 15% ROE, though I have a feeling it may be higher. That would mean an equity base of $3.34B. And that would mean a gross loan base of roughly $17B if one presumes similar leverage to MidCap (not uncommon to see consumer ABS lenders leveraged 4:1 as well).
And given ABS’s relatively short time horizons on the loans, let’s say 24 to 36 months, one needs to turn over nearly half the asset base in new origination to stay flat each year. So perhaps SPG originates ~$8B to stay flat. However, for context, MidCap appears to originate ~$4B / quarter (~$16B / yr) on an asset base of $11B, or ~50% more than its gross asset base, given substantial syndication via structured securities, 3rd party investors, BDCs, etc. In this vein, SPG origination may be dramatically higher, perhaps up to $25B, if its syndication engine is of similar or better strength versus MidCap (which seems entirely possible, if not highly probable).
To put the scale in perspective, the three-party Wheels, Donelen, and Fleet Lease transactions now total $7 billion in assets and $4 billion in annual originations, and Apollo was thrilled with this. If SPG is at the low end of my semi-truck-sized range of origination numbers ($8B), it would be a large addition to the portfolio. But if it is at the high end of my comical range, it is an absolute monster and would be the largest platform in its quiver.
Disclaimer: We own shares of Apollo. Do your own work, this is not investment advice.
AAA sounds a lot like the prefix to your local dry cleaner or local self-storage looking to be at the top of the old yellow phone book. But alas, here we are with another acronym, this time short for Apollo Aligned Alternatives, a retail-oriented fund that targets 12–15% net returns and debuted at $15 billion.
During a prior earnings call, CEO Marc Rowan declared,
I believe that [AAA] has the potential to be the largest fund across the Apollo platform by this time next year.
2Q22 APO Earnings Call
The single largest active fund by next year will likely be PE Fund X at $25 billion next year. So he hopes to exceed that figure, with the caveat that $10 billion of today’s $15 billion comes from the equity side of Athene’s insurance “float.” Moreover, it’s an outlier as a potential flagship fund because its asset mix resembles little else in the industry:
But if one is to try to understand AAA, one can pull the curtain back just a hair and see that the real question is, “What is the deal with Athene?” And that makes AAA all the more clear.
Yield
Rowan grew up within corporate private equity. Apollo’s calling card was, and still is in some sense, complex or distressed situations that result in control positions. He was a key player in Apollo’s success since its founding in the early 1990s. But by 2009, he started to ponder where Apollo’s position was, in relation to a broader spectrum of risk.
So I sit with the guy who runs the State of Illinois pension fund. And his problems are our problems. He has a group of retirees who deserve and are promised pensions. He has an obligation on his balance sheet that is discounted at 8%.
And so the question that he is asking, and that we ask him sometimes is:
Are we better off being really smart with your money, and investing only a little bit of money at very high rates of return? Or are we better off investing a lot of money at middle rates of return?
I don’t know.
Rowan 2009 Speech
Turns out, in that moment, Rowan may not have known which customer he wanted to focus on within a lower return segment, but his desire to focus on lower returning but far larger markets was clearly seeded.
Shortly after, or concurrently with the above quote, Rowan inked a partnership with life insurance industry legend Jim Belardi, who compounded annual earnings at 34% at SunAmerica from 1990 to 1998, when he received a Godfather acquisition offer from AIG. The two teamed up to reincarnate fixed and fixed indexed annuity writer SunAmerica, denovo. At the time, legacy life insurers, or specifically annuity writers, were weighed down by their prior back-books of business with the introduction of the zero percent interest rate policy by the Federal Reserve. Annuity holders were not letting go of their annuities at the typical rate of the past because, why would you? Earn 5% fixed or pull money and reinvest near zero—an easy choice. The insurers had not planned for this and were stuck paying out larger amounts for longer than they had predicted while lacking the higher-yielding assets to fund these payouts.
Rowan and Belardi founded Athene, their annuity business, on the premise that they could build a mono-line annuity writing vehicle that could help legacy players get out of their upside-down books of business and utilize the Apollo platform to source more complex and higher-yielding investment grade debt that the legacy insurers lacked the skillset to acquire. With this, Rowan’s beachhead for attacking a low return segment that dwarfs the addressable market of opportunistic private equity, was established.
At the time of Athene’s founding, Apollo was overwhelmingly still a private equity shop. Fast forward 13 years from Athene’s founding, and 70% of Apollo’s assets under management are mostly investment grade credit assets driven by Apollo’s insurance affiliates and partnerships (Athene, Athora, Venerable, Catalina, Challenger, FWD, etc.) and co-investors (that often are competitors of Athene). As such, Rowan quietly built Apollo’s Yield business into a behemoth by virtue of his work at Athene and its affiliated insurance partners.
Yield, Hybrid
Athene’s investment book comprises 95% debt (primarily investment grade) and 5% equity. While 5% equity appears small in the context of its significance to Athene, note that an insurance vehicle is about 12x leveraged. If the equity book falls by 25%, wiping out a mere 1.25% of Athene’s overall investment book, the shareholder equity supporting Athene is diminished by a whopping 15%. One can’t put Charlie Munger or Joel Greenblatt in charge of this sort of portfolio, as stability of the portfolio is a most definitely worthwhile pursuit over hero status.
Rowan has personally shepherded Athene’s equity book over the past decade to invest in a way that kept the duration of the equity book low and cash distributions high, as opposed to the general drift of the overall investment industry towards higher multiples and longer dated cash return profiles. Athene’s need for this sort of investment profile gave birth to the Hybrid business at Apollo.
[The] Hybrid business [is] a little bit different. [The] Hybrid business right now, [is] the midpoint between debt and equity. This [segment] is the beneficiary of institutional misallocation of capital. So I’ve said already, I think the world is totally awash with capital in almost every asset class. Hybrid is one of the few places where there is not too much capital chasing too few deals. Here, if you think about a typical [institutional investment] consultant and a strategic asset allocation, they typically will have alternatives in a strategic asset allocation accounting for a huge part of the return of the overall portfolio. Therefore, institutions who are consultant-driven tend to allocate to alternatives for highest rate of return rather than for best risk/reward. There is simply no bucket in the vast majority of pension funds, sovereign wealth funds or other large consultant-driven institutions for something that is a tweener, lower-risk, lower-reward equity. As a result, returns here are really good.
2021 Apollo Investor Day
What does that sort of investment look like in practice? Apollo splits its Hybrid practice between debt and equity biased products. As one example, consider Hybrid Value’s [equity] transaction with Expedia in 2020 when it placed, along with Silver Lake, $1.2B in preferred stock (along with $2B in debt from credit funds) at 9.5% with warrant kickers to compensate for call rights. No runaway upside exists in exchange for greater downside protection.
And Rowan went on to describe Hybrid’s fit with Athene’s equity book:
There is no better risk reward in fund format for Athene than hybrid value. Think of it downside protected equity, mid-teens returns, not a lot of volatility. That is among the largest investments that Athene has in fund and fund format.
2021 Apollo Investor Day
Hybrid is now a $60 billion business, larger than most investment firms. Together, Rowan and his efforts via Athene have been responsible for the roughly 70% of current AUM represented by Yield and the 11% attributable to Hybrid, totaling a whopping 81% of AUM (~$430B). In this lens, it starts to become clearer why Apollo’s prior CEO pushed Rowan to be CEO a number of years ago (answer: no), again in 2019 (no again – busy with insurance), before finally relenting in late 2020 so long as Rowan could proceed with swallowing Athene whole.
One has to wonder whether Apollo would just be another version of TPG without Athene (and with Josh Harris at the helm).
Yield, Hybrid, and Asset Originators
While Athene was a minority investment for Apollo in the past, Apollo merged entirely with Athene in 2021. Rowan described his reasoning in part:
One thing we have not forgotten at Apollo is when the market does not understand something. We are supposed to back up the truck and buy the cheap asset.
2021 Apollo Investor Day
The financials landscape, namely the more old-line financials versus FinTech upstarts, has been relatively cheap in recent times. Today, financials are littered with single-digit P/Es, especially if the company has a whiff of sensitivity to credit defaults or insurance policy risk.
Rowan filled Athene’s equity book not only with Hybrid investments but also with financials for the benefit of Athene. Namely, he has loaded up on loan originators that, when their paper is securitized, can feed the other 95% of Athene’s balance sheet consisting of investment-grade debt.
There is nothing more strategic across what we do. We get $35 billion of organic inflows every year and growing. That’s a huge part of our franchise. Asset origination this year, as I said, is $80 billion. Most of the asset origination platforms, which not only benefit Athene and Athora but benefit Apollo across the asset management landscape, are owned by Athene. They’re not owned at Apollo.
2021 Apollo Investor Day
So overall, not only has Athene’s insurance business driven the creation of Apollo’s Yield and Hybrid businesses, but its equity book is buying strategic assets for the Apollo engine that provide the dual benefit of high cash-on-cash returns to the equity book and a source of credit assets for the insurance affiliate balance sheets.
Alas, there’s more. In the past year or so, Apollo has partnered with four different investment firms to date. Jim Zelter, Apollo’s Co-President described why:
We see ample white space opportunities tangential to our existing businesses that can drive accelerated growth above our base case targets. There are a few very large and growing sectors, which typically trade at higher multiples, where we have not been historically active such as fintech, life science and software.
Over the past 18 months, we’ve selectively cultivated strategically and economically aligned partnerships with best-in-class managers in each of these areas to expand the breadth of our platform and expertise.
Apollo 3Q-22 Earnings Call
They include fintech PE firm Motive Partners, Euro life sciences VC Sofinnova, credit firm Diameter, and enterprise software and gaming firm Haveli. In each case, Apollo was able to come to the table with a unique proposition. They offered a menu of options, including an equity stake for growth capital, large investments in their underlying funds, and collaboration on distribution, capital markets, etc. While there are many out there that provide GP equity solutions, few can offer massive fund investments, as that requires material use of balance sheet capital.
With Athene, Apollo can augment its offer to buy a strategic stake with its holdco capital by buying IG securitized credit for Athene’s debt book or funding PE funds, warehouse lines, CLO equity tranches, etc. from Athene’s equity book.
In the case of Diameter, it is a direct competitor of Apollo, so why? Rowan explained:
Large UK-based alternatives competitor wants to start a broker-dealer competitive with Apollo, we provide the funding for it. Large US-based sponsor wants to start a BDC, competitive with our BDC, we warehouse the assets for them and help them launch it. CLO manager wants to compete with [our CLO division], we agreed to buy a portion of their debt and a portion of their equity. We are in an ecosystem where the value [is so large ] – we cannot do 100% of everything.
2022 Athene Retirement Services Day
So via the sheer firepower on both the debt and equity sides of Athene’s book of investments, it can offer a gigantic balance sheet to potential partners to either fill whitespace that fits its long-term vision or fund a direct competitor given the size of the market. And its offer is one that few others, if any, are configured to do.
Enter AAA. Alternatives as thought of in the past were primarily opportunistic, or better described as “high-octane” investments. Big returns.
That said, they aren’t a good fit for retail investors. Fund investing requires investing across generations to do it right, having lines to draw cash as necessary, sophisticated due diligence, and high minimums. Retail requires a lot of the opposite. One-time investments, immediate deployment, high diversification, and for the sake of a large product runway on the part of the sponsor—an investible universe that is very large. A return hurdle of low versus high teens opens up the investable universe dramatically.
The AAA effectively took 60% of Athene’s equity book as Apollo’s contribution and raised $5B from three institutional LPs. It is to be seen whether retail is actually interested in this product, so there isn’t much more to say about AAA, let alone speculation.
If successful, the firepower to drive more flow to Yield and Hybrid, to buy and grow asset originators, and to fuel existing and new Alts partnerships will track in excess of the current plan of Athene’s equity book growing from $10 billion to $20 billion by 2025 (currently $12.3 billion). So the story of AAA really is the story of Athene.
A famous entrepreneur poignantly introduced their marquee product as three separate products combined into one. While wholly incomparable, Athene is Rowan’s multi-tentacled magnum opus that has built and productized Apollo’s businesses across Yield, Hybrid, GP Solutions, a potential retail flagship, and more. I haven’t even mentioned the ADIP product Rowan pioneered that will likely sit at >$6B in cumulative capital supporting up to $100B in insurance assets, nor the investment-only tax-deferred VA product comprised of Apollo funds launching next year. The point is, Athene is the paintbrush that Rowan has used to push Apollo in a direction that is deeply distinct from the fairly identical playbooks used by most other comparable companies.
And while AAA specifically remains an odd duck, both in name and in makeup, perhaps I should have listened closer when Rowan said at Investor Day:
Our future is funded by Athene’s equity account. That is the best and clearest way I can say this.
Note: We own shares of Apollo. This isn’t investment advice. Do your own original work you lazy bum.
I have always loved the below chart. It does an incredible job illustrating how expectations have been defied constantly. In this case it references past expectations for interest rates to rise.
Now that inflation is here, the chart re-appears in reverse. I have no unique insight on the topic, but the below is a good reminder of how long something can defy conventional expectations.
Humans are pattern-recognition machines. It’s amazing to watch my toddlers have no idea how something works, say, touching a hot mug and realizing that most liquids in mugs are likely hot. In investing, most will steep themselves in the greats at the beginning (including me). The lessons are most often that one has to do something different than the crowd to get different results. But it is incredibly hard to truly think differently, as we train ourselves to see patterns and act on instinct. Being a pattern recognition machine often enables a blind spot to things happening that have no precedent.
Over the weekend, incredible events happened in China. During the closing ceremony for the Communist Congress in China, in which President Xi named a new set of leaders and was elected for an unprecedented third term, implying potential life appointment, former President Hu Jintao, who was seated next to him, was forcibly removed from his side. An unprecedented event given that the entire event is highly choreographed.
The supposed implication is that Xi is visibly showing his nation that his way is the only way. The market, made up of pattern recognizers, did not see this coming. Hong Kong’s stock index fell like a stone this morning, and is now down near 50% over the past five years, of which it is down 42% in the past 12 months alone:
Zooming out to investing globally, it is interesting to think of the 2000s when the term BRIC was used as the new frontier for investing (Brazil, Russia, India, and China). As of now, Russia is entirely un-investable and China has this weekend proven that it is likely heading in that direction. Brazil and India still appear investable, but one is undergoing an election between “Trump of the tropics” and a former criminal (which is in a run-off now).
What are the lessons here? I think one can make a nice list that would be fit for a Buzzfeed article, but in actuality, there is only one lesson. That is, protecting capital is most often more important than growing it. Greed pushes all investors out on the spectrum of risk, and investing in foreign markets that derive excess return from the idea that their internal politics will evolve towards something we can all pattern match against has proven riskier than previously perceived. In today’s markets, I personally believe that there is more than enough risk opportunity within markets we know well.
