Description

 On June 4, the Cowen Group (COWN), a boutique investment bank focused on growth equity, announced a merger with Ramius Capital, a privately-held alternative investment company.  The situation offers an outstanding risk-reward opportunity as the market has not yet seemed to give the company credit for the transformative nature of the deal.  

The downside in this situation is extremely limited: You are getting the boutique investment bank at tangible book value when many of its pure-play peers trade at a premium (the highest being 2.0x). Meanwhile you are getting Ramius, an alternative asset firm with roughly $5 billion of fee-paying capital under management, for free.  Together we believe the new company is worth substantially more than it is trading today: based on peers, the company should be worth $16.00 per share today -  more than double the current trading price. 

If the alternative asset management business which is currently below its high-water mark (and would need to return 20-25% to breakeven) can (1) earn carried interest again thereby allowing it to trade a valuation more like Och-Ziff (OZM) and/or (2) successfully increase its AUM by raising more capital (which would also pay carried interest immediately as it would have no high-water mark issue), the value of the company could be substantially more.  For reference, if the company could increase its AUM to $7.5 billion and trade closer to OZM (implying it is earning incentive fees again), it could be worth almost $40 per share.  

This transaction, which is scheduled to close in the fourth quarter, is very interesting for a number of reasons.  The new combined company will have a number of attractive investment characteristics including:

• Very Low Downside at Current Valuation: The stock is trading at 1.07x pro-forma tangible book value so downside is limited. The existing investment bank is essentially free cash flow breakeven (before working capital changes) even in a terrible environment while management asserts Ramius will be profitable post-headcount adjustments. 84% of the tangible book value is either cash or the firm's capital invested in its vehicles. The company will have no net debt.
• NewCo Should Immediately Be Re-Rated Higher: Asset managers typically trade on a % of AUM basis and if COWN were to trade like its cheapest peers, FIG and GLG its valuation would undergo a substantial re-rating. Further commentary on the appropriate valuation will be discussed below.
• Transaction Solves Size Problem: On a stand-alone basis COWN is a micro-cap: its market capitalization is only $120 million and it only trades $800k per day. This transaction will expand the market capitalization of the company to almost $450 million and make the NewCo far more investable for a larger population of investors. Liquidity in the stock will also likely improve.
• Unclear Disclosure Obscures Important Asset: GAAP accounting is very confusing in this situation and it is easy to miss the almost $6.00 per share of net cash and investments on the balance sheet. An investor may think that the bulk of this capital represents the hedge fund since the AUM is not anywhere else on the balance sheet, and he or she would therefore incorrectly exclude it from a sum of the parts valuation.
• Experienced Management Plans to Turn I-Bank from Boutique To Bulge-Bracket: Ramius founder Peter Cohen will be the CEO of the combined company. Cohen was CEO of Lehman Brothers from 1983 to 1990 while Ramius President Tom Strauss was President of Salomon Brothers from 1986 to 1991. Indeed the team stated on the merger conference call that they plan to build on Cowen's existing growth-equity platform and further expand the sales and trading business into research and investment banking functions. In particular, the team sees an opportunity to develop both a fixed-income business and a full vertical in the REIT sector. Does this sound familiar? Clearly the company is planning to build a new Lehman Brothers to fill the void left by the disappearance of both the old Lehman and Bear Stearns.
• High Likelihood of Deal Closing: Since Ramius approached COWN, it is unlikely that its partners will terminate the deal, especially given their ambitions. COWN management owns 30% of their company and is also clearly committed to the deal. Meanwhile, almost 50% of the outstanding shares of COWN have traded since the deal was announced. Shareholders who objected to the deal would have the opportunity to sell their shares into the open market and since the stock is trading at over a 50% premium to its pre-deal valuation, it is unclear why a shareholder would vote no to the deal rather than sell down its stake at current prices. Even a large shareholder has time to get out.

Business Description 

Cowen Group is a boutique investment bank with a sector focus in biotech/healthcare, TMT, alterative energy and aerospace/defense.  The company was spun out of Societe General in 2006.  In addition to its investment banking platform, COWN also owns 40% of a $500m private equity fund which buys pharmaceutical royalty streams.  Like its competitors, the company has experienced a recent downturn in its business as capital markets activity has dried up.  

Ramius is an alternative asset management firm founded in 1994 by a team of former top level investment bankers.  The company has a number of platforms including, hedge funds, fund of funds and real estate private equity.  Ramius has determined that it wants to be profitable based upon management fee income alone.  Consequently the company cut headcount by 22% from 233 employees as of March 2008 to 182 employees as of March 2009.   The company's performance in 2008 was comparable to other funds in the industry.

Because trough valuations are difficult to determine with precision, the basis of this transaction is a relative contribution of book value, or "book for book." COWN management declares that it went through every private mark on Ramius' balance sheet in detail to ensure that the book value is correct as of 3/31/09. 

From a fee perspective, the Ramius hedge funds charge 2% management fees and between 10-20% incentive allocation while the fund of funds charge 2% of assets and a 10% incentive allocations.  Finally, the real estate funds charge 1 to 1.5% management fees and 20% incentive allocations.  Note that Ramius only owns 30 to 55% of its various real estate funds.  Meanwhile, Ramius owns 100% of its hedge fund and fund of fund businesses (it is buying the 50% of the FoF business that it did not own as part of this transaction). 

In addition to its existing platforms, the company can offer its investors a customized product.  In 2008, the company started an "Enterprise Fund," seeded with Ramius partner capital, and opened it to outside investors who wanted their exposure to mimic that of the personal capital of Ramius partners.  The Enterprise Fund appears on the balance sheet as a $548m asset (this figure also includes some additional fund of funds capital).  The outside capital in the enterprise fund is $268m and, given that it is a claim against a COWN asset, appears as a liabilities labeled "redeemable noncontrolling interests" (see p. 48 of the S-4).    The firm's single largest investor represents 10.1% of assets and the top 5 together represent 20.7% of assets.  

The company cites its Assets Under Management as $7.1 billion as of April 1, 2009 however than number is misleading because it includes both the firm's capital and a cash management business, both of these do not pay fees (the cash management pays a very low fee so for our purposes we exclude it).  Current fee-paying AUM is approximately $5 billion. Ramius AUM was $12.9 billion on 12/31/07.

The following table lays out the pro-forma company's AUM, adjusting for ownership and excluding funds without meaningful economics. We have also backed out the firm's investment of its own $280m of capital although we have estimated the breakout between its hedge fund and FoF according to the total amount of each that is on its balance sheet.   For illustrative purposes, we have modeled a 5% improvement in the liquid Ramius funds' performance in the second quarter.  This contrasts to the 15% increase in the S&P500 over the same period:

The following table illustrates the historical performance of Ramius' funds and shows that, with our assumption of a 5% performance in Q2009 , the approximate performance required to be able to earn carried interest on existing AUM is approximately 20-25% (the AUM by fund is not disclosed other than the Enterprise Fund which is $420m)

 Valuation

The capitalization of the combined company is not entirely straightforward although we would steer you to the pro forma combined balance sheet on p. 48 of the S-4 filed July 10, 2009 for guidance.  The following table lays out the capitalization of the company and the accompanying book value multiples:

A sum of the parts valuation has two components:

1. The stand-alone investment bank (price to tangible book multiple of peers)
2. The alternative asset manager (% of AUM) - Note that we have included the COWN 40% ownership in its Royalty Fund here but have not made an attempt to back it out of the stand-alone investment bank's book value so we could technically be accused of double counting though the valuation is not very large

Before calculating the SOTP, we must lay out the relevant valuations of the most appropriate peer companies.  The following table illustrates the company's boutique investment bank comps:

Given COWN's new management team and its growth ambitions / successful track record, we would argue the company should trade at a premium to its peers but for the purposes of this analysis we apply the average multiple excluding BPSG which is an outlier. 

Meanwhile, the following table contains the company's alternative asset manager comps.  Not all companies transparently disclose their performance so the required gain to reach the high-water mark in the table is an imprecise estimate:

Note that these companies do not trade on tangible book value (because the earning power AUM is for the most part not on the balance sheet) as two are negative and two are very high multiples.  This validates our approach of valuing the investment bank's book value separately.

FIG and GLG are pure play alternative asset managers and have had similar performance to Ramius.  They are good comps for the Ramius fund platform. 

The high valuation of OZM reflects its history of high returns and low volatility; moreover the company is very close to earning incentive fees again.  It is unlikely that COWN would receive that multiple given its deeper trough but directionally, OZM's valuation is indicative of how valuable a carried interest revenue stream could be for COWN. 

BX's valuation also implicitly includes its profitable advisory business so its multiple is likely higher than what COWN would command all else being equal because we have valued COWN's bank separately.  Also BX is an LP which passes income through to its partners and issues K-1s.  COWN, like the rest of its comps, is a C-Corp and pays standard federal taxes. 

We assume COWN ought to trade like FIG and GLG which are its closest peers.

To understand the range of possible outcomes over time, we have also modeled a "low case" and a "high case."  The low case assumes the investment bank and the associated capital trades at distressed levels (0.75x TBV) and the asset management business trades more in line with long-only comps like AMG or IVZ or JNS.  The case also assumes AUM fall approximately 50% and the company burns $50m of cash.  The high case assumes an investment banking book value multiple at the top end of its peer group.  It also assumes the company asset base grows to $7.5b (lower than Ramius' peak AUM of over $12b), generates $50m of cash and is able to exceed its current high water mark and therefore trade closer to OZM of a % AUM basis.   

Taking these comp sets together, the following table lays out our sum of the parts valuation for COWN. Together, this analysis suggests COWN should be worth approximately $16.13 at FIG/GLG valuations with approximately 15% downside to the low case.

 Another method to value the new COWN attempts to put an earnings multiple on the company.  This analysis requires a bit of detective work in the S-4 disclosure and there is not enough information to be sure the methodology is accurate. We concluded from pages 67-71 of the S-4 that Ramius net income budget for 2010 is between $18m and $28m.  Ramius management is not speaking to investors until the final deal roadshow so it is not possible to know what assumptions are included in this figure.  Regardless, as this was a "book for book" merger, the earnings were not the driving force behind the valuation of Ramius. 

A "back of the envelope" analysis would suggest that if Ramius earned $90m of carried interest by returning 12.5% on it current asset base (at a blended carry of 13.8%) this translate into $0.91 of EPS (after a 40% tax rate).  Further assuming a 25% discount to take into account the uncertainty of when this earning stream will return reduces the carried interest EPS to $0.68.  Assuming the investment company is break-even on management fees and the consensus 2010 COWN stand-alone is correct at $3.4 million or $0.06 per combined company share (meaning Peter Cohen & Co. add nothing), together this suggests $0.74 of earning power.  Giving this a 15x multiple suggests a $11.00 stock price or 50% upside. (With no discount this analysis implies a stock price of $14.50).  Note this method is valuing the investment bank at only $50m and does not give credit for the cash and investments of $5.75 per share (which would grow with positive performance).  The imprecision of this analysis suggests the sum of the parts analysis is a better reflection of how to value COWN.

Investment Concerns

• Invested Assets Not Immediately Liquid: A significant percentage of pro forma COWN's cash and invested assets is subject to self-imposed withdrawal restrictions. The company has agreed that it will only withdraw up to $11m from the enterprise fund before 12/31/09 (p. 164 of the S-4) Some investors may not be willing to give the company full credit for the invested assets since they are not truly cash.
• Profitability Uncertain: There is no guarantee that investment bank will be profitable although the establishment of a fixed income platform diversifies the existing potential pool of business. Moreover, as of the first quarter, Ramius is not covering its costs by its management fee alone despite management's belief that it can transition the cost structure to these levels.
• Redemption Risk: Assets could always leave Ramius, especially if performance is poor. While much of the AUM has adjusted to the true believers as others have redeemed, the first lockup on Ramius' Enterprise Fund (which contains $268m of outside capital) expires on 12/31/09.
• Deal Breakage Downside Risk: Given that COWN was trading at 0.6x tangible book prior to the deal announcement, there could be major downside if the deal breaks. If the stock were to return to pre-deal levels, this would represent approximately 35% downside. Given the deal dynamics we believe it is unlikely that the deal would break and the pricing of the stock suggests that the market agrees.
• Low Trading Volume: At present, the stock only trades $800k per day which could make it difficult for larger funds to purchase a meaningful position. This volume should improve as the size of the company increases at the completion of the transaction. Volume will also improve should Ramius sell some its shares over time.
• Overhang from Large Shareholder: Ramius will own two thirds of the combined company and has agreed to enter into a voluntary lockup under which it could sell only in limited windows. This overhang could cause the shares to trade at a discount.
• Recent FoF Valuation Far Below Public Comps: As part of this transaction, Ramius purchased the 50% of its fund of funds business at a $60m valuation which equates to 2.8% of AUM. As the FoF business represents approximately 40% of Ramius AUM, this valuation would suggest that the combined company is not nearly as valuable as we have suggested. Management suggests this deal was not purely economic. Of course, BX's FoF represents nearly 50% of its AUM and the company trades at close to 15% of AUM.
• Low Termination Fee: If the transaction is terminated by COWN it is required to pay Ramius $3.5 million and up to $750k of expenses. Ramius is not obliged to pay anything to COWN. This could allow the parties to change their minds relatively easily and with limited cost.

Disclosure

We make no claims, promises or guarantees about the accuracy, completeness or adequacy of the contents of this document and expressly disclaim liability for errors and omissions in the document.  We have no obligation to update this document.  We may change our position at any time without posting an update.  The views expressed here are merely the opinion of the author.  Readers should do their own research.

Catalyst

Completion of Deal, Improved Performance at Asset Manager, Ramping Up of Investment Bank