Description
BKF Capital Group, Inc. ( BKF )- $21.75 per share - $145 million market cap
BKF is a compelling long opportunity. It has languished at or around its current valuation for several years, but during that period it has significantly upgraded the quality of its assets under management (AUM). I believe it is at an inflection point in the transformation of its business from a traditional investment management firm to a fast growing hedge fund manager. It is one of the few public market plays on hedge funds and it's cheap to boot.
Background:
BKF is a ¡§value¡¨ based investment management firm with approximately $11.6B AUM. It operates under the name John A. Levin & Co (I use Levin and BKF interchangeably). It has no Wall St. coverage, it provides no guidance, and seeks no publicity; classic orphan. BKF has twice been written up for VIC (I encourage you to see those for additional details on the traditional asset management side of the business). Today, the Company is selling for less than it was either of those times and is more valuable: I think the stars are aligned.
In 2000, right when value supposedly came back into favor, BKF fumbled the ball. Here was a value manager with a successful, long term track record that should have been able to grow its institutional account base nicely. Instead, it focused on growing lower quality, lower margin wrap accounts. From the end of 1999 through the end of 2001, these tripled from about $1.5B to $4.5B (they have since shrunk back to $2.5B). While BKF investors frowned at the growth of these low quality assets, they seemingly ignored the quiet but explosive growth of Levin's hedge fund strategies.
Hedge funds are the story of BKF today. At the beginning of 1999, hedge funds represented approximately 5.9% of Levin¡¦s total AUM ($0.5B out of $8.3B). As of June 30, 2003, hedge funds represented approximately 24% of AUM ($2.8B out of $11.3B). That is a four year, 60% CAGR for hedge fund growth. In just the past two years, BKF's hedge fund assets have doubled. In the first six months of this year, its hedge funds have grown 18% (primarily through new assets). Anecdotally, this growth has not slowed significantly (I believe it is $3.1 billion as of the end of September).
Levin's traditionally managed, long-only value accounts seem to earn 50bps or less per dollar of assets managed and do not earn an incentive/performance fee (calculated back-of-the envelope from prior years, before hedge funds meant much). Hedge funds, as many of you well know, earn quite a bit more. Levin's funds charge typical hedge fund fees: management fees of between 1.0% and 1.5% of assets and performance fees of 20% of all profits (subject to a high water mark), with a mix of quarterly and annual liquidity (the event driven strategies are subject to early withdrawal fees in each of the first two years). This is obviously a superior business to traditional long-only. It also happens to be a business standing in the way of a flood of incoming assets. More on that later.
Hedge fund strategies, by their nature, tend to be much more asset size constrained than their traditional, long-only brethren. As such, BKF intends to roll out additional strategies over time. In the early stages of a new fund's growth, BKF is the recipient of a large part of the business economics. As a strategy grows, BKF expects to slowly transition the economics more and more in the manager's favor (all the while maintaining its GP stake). This stems from a belief that BKF adds the most value early on as it seeds the manager, provides back-office and research support, and raises capital. The manager adds the most value later as its track record retains and attracts new capital. This transition allows BKF to retain its most successful managers as they achieve success.
Hedge Fund Industry Growth:
We have probably all seen the stories about hedge fund industry growth. The industry itself is estimated to be about $650 billion today and I believe that number is ready to launch into the stratosphere. My personal view is that this will come with the massive inflow of pension fund assets. Currently, the typical pension plan has zero allocation to hedge funds. That is changing rapidly. Industry leading pension plans with tens and tens of billions of dollars under management such as CalPERS, CalSTERS, VRS, and others have dipped their toes in the water with somewhat new allocations of between 0.5% and 5% to hedge fund strategies. For funds of this size, a couple percent asset allocation change can result in billions and billions of dollars. The top 300 pension funds, globally, control in the neighborhood of $5 trillion. Obviously, it won¡¦t take much in the way of a new allocation to grow overall hedge fund industry assets. More important is what it means for BKF's hedge funds: new asset inflows.
It's worth noting that large college endowments (greater than $1 billion) are often considered cutting edge institutions as far as asset allocation goes. This group, on average, has allocated nearly 20% of their assets to hedge funds with the range going as high as 66% for one endowment. The dollar size of endowments pales in comparison to the size of pension plans.
I believe that Levin¡¦s funds are ideally suited for receiving pension allocations:
„X Levin's hedge funds are managed by a firm that many institutional investors may have heard of and that has proven itself as a successful value manager over time.
„X Levin's funds tend to offer quarterly liquidity. These investors often demand it.
„X Levin's oldest hedge fund strategy has a 14 year track record and has never had a down quarter. That sort of consistency, even if it is at the expense of longer term profits, is a pension's dream. Levin seems to be targeting low volatility strategies (which makes sense with quarterly liquidity).
„X Levin offers several funds and markets another large well known hedge fund family's funds as well. Investors can get diversification across strategies while maintaining one contact point.
John A. Levin's Hedge Funds:
BKF's first and largest hedge fund strategy is focused on ¡§event driven¡¨ (and distressed) securities. The event driven portion has a track record that goes back to 1989. As of June 30th, it had approximately $2.1B in assets (split between the event driven, $1.8B, and a new distressed fund, $0.3B). Levin's marketers are not focused on raising new assets for event driven at this point though it is growing and remains open to new capital. Levin also has a sizeable short-biased strategy managed by John Levin himself, called Island Drive, that's been around for several years and has about $400 million under management. Just over a year ago, BKF launched a somewhat trading oriented, fundamental long/short equity strategy (whatever that means) called SR Capital that is co-managed by a former SAC trader. It has quickly ramped to over $300 million in assets. SR is closed until 1/1/04, but will open to a couple hundred million of new assets then. Levin says the strategy can scale to a $1 billion (that means $2 billion, IMO). SR Capital is receiving the bulk of the current marketing effort. Levin has other smaller funds that are incubating (less than $30 million AUM each), one of which may not make it out of incubation but the others appear poised to grow. I expect BKF to opportunistically launch about one new strategy per year going forward.
For the following valuation work, I've broken the hedge funds into two categories: high margin and low margin. This reflects how long the funds have been in business. The two low margin funds, event driven and short biased, have 14 year and 6 year track records respectively. They are low margin because Levin has shifted the bulk of the economics to the investment management team (while maintaining its GP stake). The remaining, newer funds are much higher margin while they gain traction.
Valuation:
Realizing that I'm no smarter than Morgan Stanley's Byron Wien, I draw the following info from his June 18, 2003 report entitled, Capitalizing Hedge Fund Values. In it Wien writes that Morgan Stanley's analyst, Huw van Steenis, who covers the Man Group (a British public hedge fund group) assigns an 14.5x multiple to management fee profits and a 4x multiple to recent incentive fee profits. Both of these are intentionally conservative. The 14.5x multiple, rather than the 18-20x that U.S. investment managers garner, is used because he considers hedge fund investors more finicky and therefore the earnings stream is slightly less reliable. The 4x multiple on incentive fee is used because it is such an uncertain profit from year to year (he considered using 6.5x but chose 4x for extreme conservatism). I think it's probably more fair to just assume 10% annual returns with an 8-10x multiple, but I'll do it Wien's way for conservatism.
Coincidentally, in Wien's report he analyzed a hypothetical $3 billion hedge fund family and reached an enterprise value of $323 mm. BKF's enterprise value today is about $82 million ($145 mm market cap - $43 mm of cash - $22 mm of advisory and incentive fees receivable - $11 mm of investment in affiliated partnerships - $9 mm investments in securities - $5 mm investment in unaffiliated partnerships + $21 mm accrued bonuses + $6 mm accrued incentive comp + $0 debt). Wien allowed for much better margins than BKF earns, but I think it begins to makes a point. Don't forget that BKF has another $9 billion of traditional assets under management.
So, for BKF's fund family:
As of June 30, 2003:
Event Driven (low margin): $1.8 billion
Short Biased (low margin): $0.4 billion
Low Margin Total: $2.2 billion
Distressed (higher margin): $0.3 billion
Other Hedge Funds (higher margin): $0.3 billion
High Margin Total: $0.6 billion
Traditionally Managed Accounts: $8.9 billion
What makes all of this difficult is that BKF won¡¦t talk about the deals they have with their managers. So I've attempted to be conservative. If I assume a very low intrinsic value for the traditionally managed accounts of 1.5% of AUM on $8.9 billion, we are building from a base value of $133 million. Already I'm getting paid a lot to own the hedge fund business and I have a margin of safety if they went away tomorrow. The hedge funds charge between 1.0% and 1.5% (event driven and distressed charge 1.5%, for the rest I use 1.0%). For the low margin funds I assume BKF gets paid 25% of the fees and the investment management team gets 75%. For high margin funds, I¡¦m assuming a 55%/45% split between BKF and the investment managers, respectively. Taxes are assumed at 35%.
So, management fees for hedge funds after compensation and taxes are:
Event Driven (low margin): $1.8 billion * 1.50% * 25% * 65% = $4.4 million
Short Biased (low margin): $0.4 billion * 1.00% * 25% * 65% = $0.7 million
Distressed (higher margin): $0.3 billion * 1.50% * 55% * 65% = $1.6 million
Other Hedge Funds (higher margin): $0.3 billion * 1.00% * 55% * 65% = $1.1 million
Total hedge fund management fee revenue after estimated comp & tax: $7.8 million
Using Wien's 14.5x multiple, we get a $113 million valuation for the hedge fund management fee (don¡¦t forget that we are discounting the fact that hedge fund AUM has been growing at 40% p.a. for the last several years and continues to grow briskly both organically and via new investment).
Now, to put a value on the performance fee, I'll assume 10% annual gross returns, 20% incentive fee, and the same fee sharing arrangement and tax rate as above.
So, performance fees for hedge funds after compensation and taxes are:
Event Driven (low margin): $1.8 billion * 10% * 20% * 25% * 65% = $5.9 mm
Short Biased (low margin): $0.4 billion * 10% * 20% * 25% * 65% = $1.3 mm
Distressed (higher margin): $0.3 billion * 10% * 20% * 55% * 65% = $2.1 mm
Other Hedge Funds (higher margin): $0.3 billion * 10% * 20% * 55% * 65% = $2.1 mm
Total hedge fund performance fee revenue after estimated comp and tax: $11.4 mm
If you use Wien's 4x multiple, the value of this aspect of the business is $46 million. I think that's extremely conservative considering the growth of the business and the annual downside is zero dollars of revenue but the upside for years when returns are big is significant. I'd probably put something closer to an 8x multiple on it if I were considering buying the business whole, but that's unnecessary to make the valuation compelling.
So here's what I see as the value proposition:
Current Market Cap: $145 million
- Pure Cash: $43 million
- Other Net Cash: $20 million
+ Debt: $0 million
Current Enterprise Value: $82 million
Value of Traditional Mgmt: $134 million
+ Value of HF Mgmt Fees: $113 million
+ Value of HF Incent. Fees: $46 million
Total Business Value: $293 million
+ Cash: $63 million
Total Intrinsic Value: $356 million
That¡¦s more than a double on today¡¦s market cap without using the cash and with rather conservative multiples and no growth.
Other things to note:
Quality owners (per the most recent proxy statement):
Gabelli (9.9%), Mr. John A. Levin (9.2%: that excludes a chunk of restricted stock), Abrams Capital (7.4%), Third Avenue Management (6.0%), and Mr. Warren E. Buffett (5.1%, not Berkshire but Buffett¡¦s personal money). Gabelli, Levin, and Buffett have owned it for some time but Abrams and Third Avenue (Marty Whitman) are both new to the story in the past year.
Eclectic board:
The board has recognizable figures from all over the map, including: Burton Malkiel (author of every value investor's favorite classic, A Random Walk Down Wall Street), Dean Takahashi (#2 guy at Yale¡¦s endowment), James Tisch (President and CEO of Loews Corp.), Barton Biggs (of Morgan Stanley and Traxis fame), and John A. Levin.
Risks:
I think the downside is limited, but I'll outline a few risks anyway:
1) Unlike most of my ideas, the thesis is not based on free cash flow as much as what it's worth in a sale. It could easily continue to languish for some time. As a counter to that, the expenses are almost all variable and could be reduced quickly to create more cash flow.
2) It's possible that I completely whiffed on the economics Levin receives from the current hedge fund strategies. My estimates are essentially correct for the high margin businesses, but I have less insight on the older businesses. I believe my valuations are quite conservative considering how much growth I ignored and the low multiples I applied, but the risk is there.
3) Poor hedge fund performance: as noted by Wien, hedge fund investors tend to be more finicky than most and can be quick to pull their money. To combat this, BKF has started locking up money for two years in the event driven strategy. Additionally, investors can take solace in its 14 year track record and the short bias fund's 6 year track record. The risk of poor performance is very real with the newer, higher margin funds.
4) If the market declines, the value of Levin's traditional asset management business is likely to decline as well. As a counter to this, one could argue that a declining market will only serve to increase the value of hedge funds.">
Catalyst
1) Hedge fund asset growth and performance will continue and eventually cannot be ignored by the market.
2) The business valuation is backed by the traditional asset management business and lots of cash and liquid investments. For the traditional business, I used a multiple of assets that would be the worst in the industry. For the hedge funds, I ignored the growth and gave the performance fee aspect very little credit.
3) The business is diversified across traditional and alternative asset management styles. BKF is trading below the value of either business on a standalone basis and well below the two businesses combined.
4) Management buyout. I have no insight into the likelihood here, but Mr. John Levin is thought to be worth more than a billion and could easily do so very profitably. It already acts pseudo-private and the costs of being public combined with the cheap valuation are compelling. A strategic acquisition by a firm looking to enter the hedge fund space is possible as well.
5) Increased management communication with the market (highly unlikely).