Description

Athene Holdings

Executive Summary
At a P/B of ~1.1x, and a forward P/E of slightly over 7x on 2019 consensus earnings estimates, Athene shares are simply too cheap. Whilst parts of the short thesis have played out in the past twelve months (notably unfavourable tax reform), this remains a company that possesses a world-class management team on both the investment management side through its affiliation with Apollo and on the liability gathering side, with industry legend Jim Belardi seeking to replicate the success he had at SunAmerica. I believe the market is being overly punitive on scepticism as to Athene’s unique investment strategy, concerns over its relationship with Apollo and its continued ability to source deals.

Company Description
Athene has been written up a number of times on VIC, both in its previous incarnation as the sole asset of AP Alternative Assets, and most recently as a short by pcm938 in May 2017. I would instruct members  to read these write-ups for more detail on Athene's history and evolution, but I'll provide a brief summary below.

Athene was founded in 2009 by Apollo Global Management to opportunistically purchase fixed annuities from motivated sellers as a result of the ZIRP and heightened regulation in the aftermath of the GFC. It grew to around $15bn of assets in less than 3 years – it acquired Liberty Life Insurance Company, Investors Insurance Corporation and Presidential Life Corporation. However, the most transformative of the transactions occurred in December 2012 when Athene announced the acquisition of Aviva USA., paying a purchase price of $1.55bn - or 57% discount to book value - to increase assets from $15bn to $60bn.

Whilst block reinsurance/M&A account for the majority of the company's early asset growth, Athene has developed strong organic growth through its retail channels, and has a multi-channel distribution platform for sourcing assets via both organic and inorganic means.

Its organic growth mainly comprises its retail franchise, which offers primarily fixed annuities (FA) and fixed indexed annuities (FIA) through independent marketing organisations, banks and broker dealers. Athene also undertake flow reinsurance, where it targets return similar to its own products (priced for mid-teens ROE).

Inorganic growth has been done mainly via block reinsurance/M&A - the most recent deal being Athene's acquisition of Voya's $19bn fixed annuities book. Management have also identified pension risk transfers as a source of growth. This is whereby a large organisation with a pension obligation pays Athene a lump sum in order to remove the obligation and Athene invests the proceeds with the goal of making an investment spread over pension payments.

As at 30th June 2018, Athene manages ~$99bn in assets.

Business model

Athene's business model is fairly simple at heart - it simply wishes to return more on its asset portfolio (predominantly investment-grade credit) than it pays out in premiums to policyholders. Unlike traditional insurers, Athene allocates a higher proportion of assets to structured credit and alternatives in order to derive higher yield.

Athene's Asset Portfolio Q2 2018

Below is the basic business model, laid out by management in their most recent Q2 2018 earnings presentation.

Management targets a mid-to-high teens return on equity.

Key investment strengths
•    World class management team: As mentioned in the previous write-ups, Jim Belardi who founded Athene with Apollo is an industry legend, having been Eli Broad's right-hand man at SunAmerica, where he built a very successful net investment spread business during the 90s that was ultimately sold to AIG at a substantial premium to book. Belardi's goal with Athene was to essentially re-create his SunAmerica experience.
•    Favourable secular tailwind: As more baby boomers reach retirement age, they will naturally be looking for retirement income products, which should support multi-year demand for annuities. There is also upside optionality in underlying demand for annuities, should interest rates rise in the future.
•    Exposure to faster growing FIA segment: Athene's retail channel predominantly sells FIAs, where it is amongst the market leaders and one where that has been growing at a faster pace than FAs.
•    Tax-advantaged structure: Athene reinsures 80% of its US retail premium and funding agreements to its wholly owned Bermuda-based entity, allowing the entire company to benefit from a single-digit tax rate. This allows Athene to pass this benefit onto consumers, resulting in more competitive pricing and also makes flow re-insurance more competitive, as Athene is able to share the tax benefits with its counterparties.
•    Strong credit rating/opportunities in institutional market: Following the upgrade in Athene's rating to A/stable by AM Best, this should allow Athene to improve distribution through the bank/broker-dealer channel (currently they are more reliant on several independent marketing organisations). This should also allow Athene to pursue more deals in the Pension transfer space, where counterparty risk is a strong selling point.
•    Management's capital allocation track record: Management have proven themselves at being adept at taking advantage of market dislocations, in order to scale the business to its current size. Also, whilst opportunities currently may not be as advantageous as they were earlier in Athene's life, management has shown the ability to creatively structure complicated deals, as evidenced in the recent Voya transaction, where the company capitalized a separate entity to take on Voya's variable annuities, allowing Athene to take on the fixed annuities. When combining management's strong capital track record with dry powder in the form of excess capital and borrowing capacity, this represents an unquantifiable source of future upside.
•    Apollo's investment track record: Apollo have proven themselves over the years to be amongst the savviest investors in both private equity and credit markets, with a keen understanding of market cycles and a value-oriented approach.

Despite the growth in Athene's liabilities, earnings and book value, the share price has floundered in the past twelve months. I believe that this is largely the result of market concern over several of the issues identified in pcm938's (very well written) short thesis on Athene. Below is a brief summary of the major points that pcm938 and others have raised, along with my counter as to why the issue identified has either diminished or my alternative viewpoint (for further detail I encourage you to read pcm938's short thesis).
•    Athene's investment strategy, which is different from industry norms is unproven/risky: Unlike traditional insurance firms, which hold the majority of their assets in liquid government securities and investment-grade corporate bonds, Athene seeks to add additional spread by taking on complexity and illiquidity risk as evidenced by its far higher allocation to structured securities. The charge from pcm938 and other bears is understandably one of scepticism, as to what risks are being taken to achieve these higher spreads. I can speak from my experience in a past life, working at the corporate loan hedging desk of an investment bank. I always felt the amount we had to pay in premiums and the difficulty hedging illiquid loans was disproportionate to the incremental risk, and that our counterparties were getting a great deal. That was just looking at one credit asset class (corporates), and I believe the ability for a savvy credit investor to add alpha without necessarily incurring extra default risk is a valid investment proposition. Also, given that Athene has a greater degree of certainty around the maturity of its liability base, I don't feel it necessarily inappropriate to be taking additional illiquidity risk, provided the underlying underwriting is sound. Frankly, I sleep much better at night with the credit book of Athene, knowing that it's been managed by principals with a value-oriented mindset, than that of a typical commercial/investment bank credit book, which is primarily driven by originators looking to meet asset growth budgets and/or on deal heat.
•    Risk that tax reform could disallow current structure: This part of pcm938's short thesis has played out to some extent, as the application of the Base Erosion and Anti-Abuse Tax (BEAT) impacts Bermuda-based insurers, conducting reinsurance activities in the US. This does reduce Athene's tax-advantaged state going forward, however whilst there remains some uncertainty as to how this will finally play out, management is guiding for an overall rate of 11% going forward. I think the key point is, whilst there is uncertainty around magnitude of the tax advantage going forward, this should still be a source of strength to Athene's investment thesis, albeit at a less favourable rate. From the Q2 conference call:

Ryan Krueger (KBW)
On the tax, is there any more detail that you can provide on what you changed structurally? And then -- I think certainly providing if you can. But along those same lines, can you talk to your confidence in the sustainability of the tax rate and not being at risk from any sort of IRS interpretations around these or other factors?
Marty Klein (Athene)
Yes, Ryan, and we're not going to get into a lot of detail on something we haven’t even executed. We don’t really think it kind of serves our best purposes here for competitive issues. But I would say that earlier in the year we put in place structural changes to make sure that our tax rate was no worse than 14% or 15% no matter if the interpretation would be with gross or net. Actually what we’re doing now is putting in place a business model change incrementally that will drive our tax rate down to no more than 11%, we've already got a tax opinion from a blue-chip firm, been through it with our auditors and other tax advisors, and now it's just a matter of implementing that strategy. Obviously nothing is absolutely certain these days and the actual rules of tax reform are not finalized, but we feel pretty good about where we are.

•    Annuities are sold, not bought: The charge levelled here is that if it wasn't for the manner in which marketing agents were incentivised, the underlying demand for annuities would be lower than it is. I certainly have some sympathy for this arguments, especially given I never personally would never buy annuity for retirement planning purposes. However, social utility of the product aside, I still prefer use a marginal analysis framework and ask what would change going forward that would reduce future demand from current levels? Now one issue that certainly supported pcm938's short thesis was the potential impact that the implementation of the DOL fiduciary rule would have to qualified FIA sales. However, with this off the table (at least in the near-term) after the rule was deemed invalid by a three judge panel at the 5th U.S. Circuit Court of Appeals, this risk appears substantially reduces. Furthermore, even if there is future regulation that adversely impacted the retail sales of FA/FIA products, this would likely see an exit from industry participants and given Athene's track-record in deal-making, this could see block reinsurance/M&A activity undertaken at favourable levels.
•    Fundamental conflict of interest between Apollo and Athene: Athene Asset Management (which is mostly owned by Apollo) received 40bps from Athene for the investment services it provides. There is naturally a tension whenlooking through a lense of pure incentives, it's in Apollo's interests for Athene's AUM to grow as much as possible, even if that growth is not necessarily value-additive to Athene shareholders. To date, the majority own block reinsurance/M&A appears to have been from motivated sellers (Aviva USA, Delta, Lloyd) and management have appeared disciplined in that regards. Furthermore, Athene has been quite vocal about the ROE it targets via both its retail channel (mid-teens) and block reinsurance/M&A (15-20%+) so any prolonged decrease would be scrutinized by investors. It is in both Apollo's and Athene's interest for assets to grow, provided this is undertaken in a disciplined manner, with regards to targeted ROE returns. Athene's growth plays a core role in Apollo's move to increase 'permanent' capital, which should in theory command a higher earnings multiple than from its private equity vehicles.

Valuation:
When pcm938 wrote his/her short thesis, Athene was trading at P/B (ex-AOCI) of 1.6x. He/she believed Athene, should only be trading slightly above book value, based on the points outlined in their short thesis (and summarised above).

Whilst I clearly disagree with some aspects of pcm938's short thesis, I acknowledge that on several of the points raised and my rebuttal, there are points where reasonable minds can disagree.

However, Athene is now trading at a P/B of ~1.1x, and a forward P/E of slightly over 7x on 2019 consensus earnings estimates. I believe the pendulum on sentiment reflected in these valuations has clearly swung towards the bears, that the stock is simply too cheap and that the risk/reward to going long appears far more favourable.

Catalyst

Continued growth in Book Value per share