On December 15, investment bank Morgan Stanley MS issued a research note titled "Cash In On the Harvesting Super-Cycle," initiating coverage on six U.S. publicly traded private equity firms.
The three alternative asset manager Overweight picks were The Blackstone Group L.P. BX, KKR & Co. L.P. KKR and Oaktree Capital Group LLC OAK.
These firms appeared to have the most upside when it comes to "harvesting" investment wins during the 2015 to 2017 time frame.
Morgan Stanley had one Underweight pick: Apollo Global Management LLC APO.
One factor that contributed to Apollo's predicted underperformance during the next three years is simply due to Apollo being in a different part of the cycle -- resulting, most likely, in less distributable income (DE) during that time frame.
Rounding out the Morgan Stanley "Big 6" were two Equal-weight firms: Ares Management LP ARES and The Carlyle Group LP CG.
New Coverage - Summary
KKR & Co. typically commits more "general partner" balance sheet equity, which can end up turbo-charging returns on successful deals realized by the firm.
However, this also results in a greater risk profile than the other two Overweight firms, which is reflected in its Bear case price range above.
Private Equity 101 - Buy It, Fix It, Sell It
Asset Management Fees: Usually, 1 to 1.5 percent of assets under management (AUM).
Investment Income: Typically, these firms invest 2 to 5 percent of equity alongside their limited partners. This "skin in the game" usually generates a relatively small percentage of overall firm revenue.
Performance Fees: This is the win/win, where limited partners first receive a preferred return, or hurdle rate (typically in the 8 percent range). PE firms then accrue earned performance fees (typically 15 to 20 percent range) that are realized when assets are sold, refinanced, or other liquidity events occur, such as sponsoring an IPO.
Tale Of The Tape
As a group, these asset managers did not have a banner year in 2014, which is a factor that Morgan Stanley feels might act as a tailwind for these firms moving forward.
Why Do They Trade At A Discount?
Two factors that contribute to Mr. Market undervaluing alternative asset firms versus traditional asset managers mentioned were:
1. The PE firm partnership structure, which results in K-1s being issued to unit holders, is not as attractive to some investors as a C-Corp. structure. There is a headwind from the potential change of how "carried interest" (performance fees) taxation might increase moving forward. Morgan Stanley took this into consideration when calculating its best, base and worst-case scenarios.
2. The difficulty of estimating the "episodic nature" of performance fees. The Morgan Stanley approach is this: Look at how fees are expected to spread over the next three years, to help reduce the lumpiness inherent in quarterly estimates.
Each Firm Has A Unique Approach
When it comes to portfolio composition and concentration, each of these firms has a different approach (reflected in the AUM table below).
Company Differences
Blackstone: It is described by Morgan Stanley as a "best-in-class franchise at a bargain price." Blackstone's balanced asset allocation and global real estate moat were viewed as a plus.
KKR & Co. It has almost $10 billion of general partner investments on its balance sheet, which should serve to increase investment earnings significantly for the firm compared to its peer group.
Oaktree: Its strategies put it closer to a traditional asset manager when it comes to valuation multiples. Morgan Stanley pointed out that the firm's "counter-cyclical" debt strategy could be a good hedge, when combined with owning Blackstone and KKR in a portfolio.
Apollo: It has a considerable investment in Athene, an insurance company that APO also advises. Morgan Stanley described this as more of "long-tail investment," which will likely not contribute significantly to DE during the near term.
Ares Management: This is described as a "promising growth story," but Morgan Stanley said this idea was largely priced into the stock.
Carlyle Group: It derives the majority of its earnings from (potentially) volatile performance fees, which investors usually assign a lower multiple. However, Carlyle's large number of private equity partners and global footprint were viewed as a plus.
Big Picture
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