Description

PDF with images here: https://docs.google.com/file/d/0B1rLnZbnV78ZWE1ubHFtR2M1VWc/edit

Although AP Alternative Assets (“AAA” or the “Company”) has units that trade OTC in the USA under the symbol APLVF, the company's units primarily trade in Amsterdam under the symbol AAA NA.  AAA outsources all of its operations to Apollo Global Management (“APO”) so “AAA” and “Apollo” are used interchangeably herein.

AAA’s earnings power is poised to more than triple later this year when a recently announced acquisition by its 73% owned insurance subsidiary closes.  Yet when the acquisition was announced, AAA’s unit price was unchanged.  While the units are now up ~50%, we believe they still trade at less than half of fair value as the market does not appreciate the transformative nature of the acquisition.  While management has gone out of its way to prevent us from getting up to speed, we will walk you through what we have pieced together.

Importantly, once the acquisition closes, it is likely management will be much more open about the Company as they will IPO their insurance subsidiary in the next couple of years.  While there is some deal-risk, AAA’s insurance subsidiary will be both highly profitable and overcapitalized by about $1 billion (compared to AAA’s $1.7 billion market capitalization) if the acquisition falls through.  Because AAA’s management team has a long history allocating capital effectively, we feel pretty good about our downside.

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Keeping Unitholders in the Dark

AAA is a closed-end fund formed in 2006 under the laws of Guernsey in order to invest in and alongside Apollo Global Management (“APO”)-sponsored vehicles.  Like most closed-end funds, AAA has historically traded at a premium/discount to NAV.  Looking at page one of the July 31, 2006 IPO prospectus, you can see AAA’s investment strategy:  “We anticipate that over time, approximately 50% of our capital will be invested in private equity…In addition to our investments in private equity, we anticipate that capital will be deployed through investments in, or co-investment arrangements with, Apollo’s capital markets-focused funds.”

Until six months ago, things were playing out as expected for AAA unitholders.  On September 30, 2012, AAA’s investment portfolio was allocated 55% to private equity and 16% to capital markets investments, which is roughly in line with what investors were promised.  You see, investors buy AAA because they want access to a diverse pool of alternative assets handpicked by one of the largest and most successful private equity firms in the world.

As an added bonus to unitholders, AAA has historically traded at a large discount to NAV.  The thesis for AAA for many years had been that the discount to NAV should shrink as highlighted in ele2996’s post on VIC in April 2012:

“Having a public fund trade at a 40+% discount to NAV is a vote of "no confidence" by the markets. It is a situation that Apollo must rectify. Why invest new 100% dollars when you can buy a fully matured, freshly priced, liquid portfolio at a big discount to NAV?”

AAA units are up over tenfold since we first looked at them, and regrettably did not buy, in 2009 as NAV has grown and the unit’s discount to NAV has shrunk.  We have learned our lesson.

 http://i.imgur.com/7YHzBOh.png

AAA unitholders slept well on October 30^th 2012 knowing they owned a well-diversified pool of alternative assets trading below their fair market value.  However, when they woke up the next day, everything changed.  AAA contributed all of its private equity and capital markets investments to a life insurance company named Athene Holding Ltd. (“Athene”) in exchange for a larger equity stake in it (“Transaction 1”).  Magically, AAA unitholders owned 77% of Athene (now 73% as a result of contributions by minority shareholders) and that’s about it.  There was virtually no information available on Athene as it is private and its assets are mainly offshore. 

Further complicating matters for unitholders was the fact that they had a decision to make.  Concurrent with Transaction 1, AAA announced a Dutch Tender offer for up to $100 million (or about 9% of the market cap) of its units at a 14% to 20% premium to its October 30th closing price.  All the smart-money insiders including management, Apollo execs, and a mysterious 40% AAA unitholder (later leaked by Bloomberg to be one of Apollo’s largest LPs, Abu Dhabi Investment Authority) agreed not to participate in the tender.  Unitholders could either blindly follow the insiders or sell out at what was likely hefty profit.  We’re pretty confident AAA/Apollo’s telephones got lit up by angry and confused unitholders.  A summary of the Transaction 1 is below:

 http://i.imgur.com/CarQzMa.png

Though unitholders have virtually no rights with respect to Guernsey-based AAA, management decided to throw them a bone.  On February 6, 2013, AAA posted some information on Athene on their website including (i) a 27-page presentation on Athene that might as well have been written on a napkin, and (ii) 2009-2011 audited GAAP financials.  They can be found here:

http://www.apolloalternativeassets.com/ViewDocument.aspx?f=MHAR_AAA_Presentation_2_6_13.pdf

http://www.apolloalternativeassets.com/ViewDocument.aspx?f=OCMO_Athene_Audited_Financials.pdf

Two days later, AAA hosted a conference call, which featured both the CEO and CFO of Athene (don’t waste your time looking for a replay or transcript as they don’t exist anymore).  The Cliff’s notes version of the call is below.

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Athene was created to insure and reinsure fixed annuities.  Fixed annuities guaranty policyholders a stable stream of cashflow for a set period of time.  They are priced at a slight premium to comparable-duration treasuries in order to entice yield-hungry babyboomers.  Essentially fixed annuity insurance is a “spread business”, whereby the insurer earns the difference between the investment return on its assets and the rate it pays on its fixed-annuity liabilities (AKA its “crediting rate”). 

Given the current low interest rate environment, spreads are extremely tight for fixed annuity insurers, who mostly invest in government-backed and high-grade fixed income.  Tight spreads means low ROEs, which in turn means that annuity franchises trade at steep discounts to book value.  It’s no surprise that many life insurance companies with fixed annuity operations and their shareholders want out of the business. 

Enter Apollo.  Apollo founded Athene to acquire fixed annuity books at steep discounts to book value.  Apollo would then reinvest the assets at higher yields, increasing “the spread” and in turn net income and ROEs.  Athene also now originates new policies through their retail distribution business.  Apollo hired Jim Belardi to run Athene.  Jim described his impressive background on the call:

“I worked 20 years for a company called Sun America with a gentleman named Eli Broad running a net investment spread business there. And it was a great place to work. I learned a lot about how to make money, the right things to focus on in this business. Essentially interest rate risk is a key risk to focus on. And it’s always great when what you’re doing is very successful, and we were at Sun America. It was the best performing stock under the New York Stock Exchange during the 1990s, appreciating 213 times, 21,000% during that time period. And we eventually sold the company at a book value multiple of 6.6 times. So terrific performance. I decided I wanted to continue on my career, putting in place a new company that focused on the same things that were so successful at Sun America and that was the original backdrop to starting Athene.”

Athene’s goal is not to earn 15+% its investment portfolio as Apollo does in their private equity funds, which at 10-15x leverage isn’t viable.  Rather, Athene seeks to earn and extra 1-2% “alpha” over their beta-only peers without taking on material additional risk.  Apollo accomplishes this by diversifying about 10% (compared to 2% for peers) of the portfolio into alternatives (Apollo-managed private equity and capital markets vehicles), but also being more opportunistic with Athene’s core high-grade portfolio – including an incredibly well-timed bet on non-agency, mortgage-backed securities during the downturn (31% allocation compared to 11% for industry).

http://i.imgur.com/Vmoqkp7.png 

For Apollo this is a win-win situation.  On one hand, they generate substantial value at Athene buying cyclically distressed (i.e. cheap) annuity franchises and then leveraging (literally) their asset management expertise to boost ROEs.  This creates substantial value for Athene’s shareholders (e.g. AAA) and should command a premium valuation over other annuity franchises.  On the other hand, Athene generates substantial fee-paying assets-under-management (“AUM”) for Apollo.  At March 31, 2013, Apollo Global Management had $113 billion of AUM.  Apollo will soon be managing $59 billion of assets for Athene.  Make no mistake, Athene is an integral part of the future of APO (see risks for further discussion of asset-management fees).  Rational investors may dispute the amount of long-term value Apollo will create at Athene.  We believe their track record speaks for itself.

 http://i.imgur.com/9YbYqMl.png

On slide 12 of the February 2013 presentation, you can see that Athene targets a “spread” (investment return less cost of funds/reserves) of 2.5% in today’s environment, which translates into 16-20% ROEs (depending on leverage level) after factoring in overhead and taxes.  On slide 14, you can see what actual results looked like in 2012.  Athene’s 2012 “spread” was 3.01%, which resulted in a 27% ROE before realized and unrealized gains.

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Back to our story.  Unfortunately, most of the financial information AAA provided about Athene on the call (and until today) was about to be rendered obsolete and fairly useless.  On December 21, Athene announced the acquisition of the US annuity and life business of Aviva Plc (“Transaction 2”), which is expected to close in Q3 and will completely transform AAA once again.  Pro forma for Transaction 2, Athene’s assets will increase over 4x, earnings over 2x, and its ROE will spike to 40ish percent.  Despite the game-changing nature of Transaction 2, AAA/Apollo dedicated just one slide (the last one) with ten bullet points to Transaction 2 in the February 2013 presentation.  AAA took only emailed questions on the February 8th conference call, which allowed them to dodge all the tough ones, including what Athene will look like after Transaction 2 closes.  When you call AAA investor relations, you get the same guy who is responsible for fundraising for the various Apollo funds.  He seems like a nice-enough guy, but has virtually no knowledge of Athene.  “I’ll check with the team and get back to you on that one,” and then a few days later “we can’t answer that question” is all we have been able to get out of him. 

On its Q1 2013 conference call on May 6th, AAA regurgitated the February 8th presentation only this time they removed the one slide on Transaction 2.  Once again, AAA management refused to answer any questions on Transaction 2: “A lot of questions about purchase accounting, pro forma balance sheets, GAAP, stat.  All I can really say there is we are still working through the purchase-GAAP accounting. We will provide pro formas at some point in the future when that’s complete and we will provide a bridge from GAAP to Stat.”  Hard to believe that five months after they announced the deal, they’re still working through the pro formas.  Again, don’t waste your time looking for a replay or transcript of the Q1 call.

Given the transformative nature of Transactions 1 and 2, and AAA/Athene’s secretive management teams, it is no surprise that unitholders have struggled to get up to speed and that the stock trades at a substantial discount to fair value.  However, recent mainstream press about the pending acquisition seems to have attracted some institutional investors to AAA, who are digging in.  On April 19^th, Jody LaNasa of Serengeti Asset Management outlined his bullish thesis on AAA in Grant’s Interest Rate Observer.   On April 22^nd, Bloomberg reported on heightened regulatory concern over Wall Street’s entrance into the fixed annuity business (regulatory risk is discussed later):

http://www.bloomberg.com/news/2013-04-22/apollo-to-goldman-embracing-insurers-spurs-state-concerns.html

While the story was clearly negative for Athene and its pending acquisition of Aviva, the units rallied 17% over the next four weeks on three times the average daily trading volume from the four weeks prior the story.  We can only postulate that some investors are getting smarter on the situation.  While Jody provided some tidbits from his analysis along with his (conservative in our view) target price for AAA units of $47, he left out the all the details.  Below we attempt to fill in some of the gaps.

Shedding Light on Transaction 2

Disclaimer: Given the limited information on Athene and Aviva, the following is high level and likely incomplete.  It is also worth noting that we are not experts on statutory or P-GAAP accounting.  However, our estimates seem to be in line with management commentary. 

Athene paid just $1.55 billion or 57% of book value for Aviva.  Because Aviva’s the legacy annuity liabilities are priced at higher rates than currently offered in the market, those liabilities must be “marked up” or increased by approximately $1.15 billion under P-GAAP, which marks-to-market.  Liabilities are not remarked under statutory accounting standards.  Overall, the pro forma balance sheet and income statement will look something like this:

http://i.imgur.com/GqDMs5l.png

As a result of Transaction 2, Athene’s leverage will increase substantially from 8x to 15x and 32x, from a stat and GAAP perspective, respectively.  Using the “spread” assumptions given by Athene on AAA’s Q1 2013 conference call, we can see that GAAP earnings power (once assets are reinvested) will increase 268% compared to the actual 2012 results, yielding an annual ROE of 41% based only on spread income (i.e. before any capital gains).

Prior to AAA pulling the Q4 2012 conference call replay from their website, we transcribed the following.  It seems our math is roughly in line with management guidance.

“From a GAAP perspective, post-Aviva, our balance sheet will look a bit stretched and that is because under the P-GAAP, or the acquisition, and because of the low discount price that we’re paying, of the $1.55 billion we’ve asked for a relatively large, extraordinary dividend to come out of Aviva as part of that. So our net effective purchase price is quite low, and from a P-GAAP perspective that’s reflected as the contribution and the equity in the deal. So pro forma, at the end of 2013, on a GAAP basis, management view, we’re expecting that our leverage will be relatively high, about 25 times. And on a 10K view even higher, about 30 times. We focus on statutory capital. We will be in great shape from a statutory capital perspective, and because we expect to be highly profitable over the next couple of years, we will quickly earn down the gap leverage.”

Value Investing 101

It’s natural to be skeptical of the value creation from Transaction 2.  Quadruple GAAP leverage, and voila, earnings power more than triples.  Doesn’t more leverage = more risk = high discount rate on those future earnings?  The short answer is yes.  However, Apollo’s key insight is that the increase in risk/discount rate is not commensurate with the increase in return/ROE. 

Fixed annuities represent stable (fixed rate) and uncorrelated (the market for annuities continues during a recession when other forms of financing dry up) long-term financing.  In addition, policyholders are less sensitive than traditional lenders to changes in their insurer’s credit risk.  Most importantly, fixed annuities are priced lower today (i.e. cheaper financing) than ever.  How many corporates could increase GAAP leverage from 8x to 32x at all, let alone without significantly increasing their cost of debt?  How many 32x levered businesses have lenders banging down their door offering eight-year, sub-4% financing?  You see, the additional leverage assumed by Athene in the acquisition is not efficiently priced, which creates substantial value for Athene shareholders and, in turn, AAA unitholders. 

Given their asset-management expertise, Apollo is uniquely positioned to take advantage of a once-in-a-generation opportunity to acquire billions of assets/liabilities at fractions of their intrinsic value.  On the other hand, life insurance companies are both unequipped (less investment expertise) and unmotivated (shareholders pushing for divestitures of low ROE fixed annuities not acquisitions) to dig in.  Be greedy when others are fearful.

Charlie Munger has said that the secret to Berkshire’s success has been its ability to “generate funds at 3% and invest them at 13%.”  The key to Athene’s success will be to generate funds at 3.5% (the Aviva acquisition will generate $45 billion of such funds) and invest them at 6% (Apollo’s track record speaks for itself).

What’s it worth?

AAA currently values Athene units at 1.23x GAAP book value (excluding AOCI).  This is arguably very conservative compared to comps.  Looking at the regression below showing P/BV on the y-axis and ROE on the x-axis, one might argue that Athene’s 20% ROE target should command a multiple closer to 2x book value and even higher based on their historical ROEs. 

http://i.imgur.com/AWyIqEb.png

Below are simple 5-year GAAP financial projections for Athene pro forma for Transaction 2.  While leverage is quite high (and also, ROE) in years 1 and 2, Athene quickly earns down the leverage.  By year 3, Athene’s leverage is more in line with its peers at 17x, which yields a 25% ROE.

http://i.imgur.com/ghORgfu.png

In terms of valuation, we have used both AAA’s conservative book value multiple of 1.23x and a P/E ratio of 10x.  In year 3, these multiples imply AAA unit price of $49 to $80 per unit compared to the current trading level of ~$23.

What the smart money is doing

• AAA disclosed that Apollo (though Euronext disclosure is horrific, we believe Apollo owns 5-10% of AAA currently), its executives (~3% holders) and a significant unitholder (i.e. Abu Dhabi, who we estimate now owns about 42% of AAA) did not participate in the tender offer as part of Transaction 1
• It is also rumored that as an alternative to Transaction 1, Abu Dhabi Investment Authority expressed interest in swapping their AAA units for a direct stake in Athene.  We believe Apollo manages (and receives carried interest on) Abu Dhabi’s interest in AAA.  In addition, Abu Dhabi and CalPERS (10% holder of AAA units), have invested over $7.6 billion in Apollo funds.  
• Apollo seems to prefer stakes in AAA/Athene to cash compensation:
  • Apollo earns “advisory fees that Apollo wins from Athene…for which we now receive this equity interest in Athene in lieu of cash. As the manager of both AP Alternative Assets and another strategic account that is invested in Athene, Apollo also has the ability to earn carry interest income, which is ultimately based on the underlying value of Athene and is also payable in equity interest” – APO Q1 2013 conference call
  • In connection with the Transaction 1, “AAA entered into a derivative contract with Apollo Alternative Assets. Apollo Alternative Assets is entitled to receive management fees from AAA in accordance with the services agreement. All the management fees pursuant to the Services Agreement are to be satisfied by AAA's transfer of units of Athene (or a derivative equivalent thereof) to Apollo Alternative Assets with such units being valued at the most currently available fair value as determined by AAA.”
• Leon Black is significantly smarter and wealthier than we are. 

Athene IPO

AAA unitholders, who expected to own a diversified portfolio of alternative assets, are not natural holders of Athene shares long-term.  Apollo knows this:  “I think most of the focus that we will have at AAA post-tender, is to figure out strategically what it is we’re going to do with AAA’s holdings of Athene and I think the options are relatively straightforward and we’ve run through them previously.”  The preferred exit will be an IPO of Athene.  Alternatively, Athene shares will be distributed to AAA holders.  In terms of timing, while a lot will depend on market conditions, we believe late 2014 or 2015 is realistic.  The IPO of Athene and subsequent transition of its shares to more-natural holders will provide a meaningful catalyst for AAA units.

Risks / Considerations (happy to discuss in more detail in Q&A)

Aviva doesn’t close.  Regulatory scrutiny is increasing on private equity and its participation in the insurance industry.  Benjamin Lawsky, New York State's first Superintendent of Financial Services, has been especially critical of private equity’s involvement in fixed annuities.  The media has also caught onto the story.  At a recent public hearing in Iowa regarding Transaction 2, Jim Baker of UNITE HERE laid out the case against the deal –

http://www.pecloserlook.org/wp-content/uploads/JBaker_Testimony_Iowa_re_Athene_7-17-2013_Final.pdf.

We are happy to address any of Baker’s concerns in Q&A. 

We think the deal is very likely to be approved with some concessions to appease Lawsky.  The reality is that the other competitive bidders (Guggenheim, Harbinger) are also alternative asset managers.  Furthermore, the deal could potentially close without including the NY subsidiary.  Lastly, Lawsky just approved the $1.35 billion Guggenheim/Sun Life deal, whose closing was delayed in June pending further regulatory review, with only modest concessions.

Apollo’s perverse incentives:  As external manager of the vast majority of Athene’s assets, Apollo stands to earn an estimated $300+mm annually in fees.  Thus, regardless of how Athene performs, Apollo and its execs make out well.  This creates a conflict of interest.  Mitigating this to some extent is that Apollo and its LPs own a significant percentage of AAA’s units.

Business isn’t revalued.  There is the potential that market does not fully appreciate the value creation from Transaction 2 and assigns a higher discount rate than we do.

Business blows up.   While we do not possess detail on Athene’s liabilities, we have run stress-tests on what we believe to be similar liabilities.  It would take both a significant increase (2+%) in interest rates and widening of credit spreads for Athene’s capital to be impaired.  Also, Athene can manage its liquidity risk by offering higher crediting rates when there are lapses.

Catalyst