Description

Patrizia SE – Cheap valuations creating an asymmetric investment opportunity

Elevator Pitch:

A top-3 European real estate asset manager with a strong balance sheet (25%+ of market cap as net cash) is available at 20 bps of AUM and 0.6X Price to Book despite having an owner-operator who has compounded book value per share at 15.5% over the last decade. Potential to get re-rated as a capital light compounder with a recurring earnings stream. 

Investment Thesis:

1.) Successful business transformation !

Patrizia has transformed from being a capital heavy real estate operator into an asset light investment manager with 56 billion Euros of AUM and 500+ institutional clients. In 2012, over 94% of the firm’s income was from principal investments/ real estate operations and in 2022, almost 95+% of income is through fee based sources. 

Patrizia is now a scaled up platform as the firm has grown AUM at 24% CAGR (including inorganic) over the last decade. Over 80% of their AUM is in perpetual or 10 year+ vehicles and that provides strong resiliency to the business through a predictable management fee stream. 

Their historical experience as a real estate operator has allowed Patrizia to have an in-house development and asset management team and that provides their investment team an edge in buying distressed properties and to reduce execution risk in complex transactions. 

Recurring revenues with solid growth

Scaled up platform

2.) Conservative culture !

Patrizia at its core has a conservative Bavarian culture anchored by the 54% ownership by the founder. This conservatism exhibits itself through balance sheet leverage, valuation markings, employee remuneration, portfolio mix, carry accounting etc. 

Over 80% of the real funds are in the Core & Core+ categories compared with just 20% in the higher risk value-add segment. Patrizia does not accrue carry income to the financial statements until realized except in SPVs where IFRS forces them to. The leverage on their properties is also lower than peers with an average of 33% LTV. 

Their valuation marks are conservative as they have always used a 10-year average discounting rate and thus never benefited as much as their peers from the declining interest rates of the previous few years. The unaccounted carry provides a buffer to the current valuations. This allows the management to be confident that even with the current dislocation in interest rates, their AUM valuations could be hit by <5% over the next 12-18 months, indicating lower volatility than peers. 

Strong Balance Sheet

One large balance-sheet investment (Dawonia)

Well diversified - Strategy, Client & Asset Class

Low Management Remuneration

I am not sure if this is a long term negative, but the management remuneration is extremely low compared with other alternate asset management businesses. This is also a reflection of their conservative culture. Low management remuneration could be a long term issue as they would need to attract good investing talent to succeed in newer asset classes that the firm has entered over the last few years. 

3.) Resilient Investment Performance:

The long term performance of their funds is healthy with a 4.2% out performance versus benchmark.

Management wants to be a strong buyer of assets during the current market dislocation. They have cash at both the holding company level and at the funds level to take advantage of the current crisis. During the 2013 crisis, Patrizia was able to acquire a South German residential portfolio (Dawonia) in which their investment of 115 million Euros has grown to 550 million Euros today (net of deferred taxes) as they have benefited from performance fees in addition to the underlying value appreciation. 

On a normal year, transactions are 10-15% of AUM and that provides Patrizia with lucrative fee income along with an ability to book carry income. With the current market uncertainty, I believe that the transaction and performance fee streams should be weak for the next few quarters. The management expects to get to 250 million of management fees yearly in the medium term and that should provide strong visibility on profitability. Management expects AUM to continue its organic growth of 8% even during this tough environment.  

German Real Estate is a very resilient asset class

4.) Capital Light Growth:

The firm does not need any incremental capital for growth and hence I would expect strong dividend payouts going forward (upwards of 75% of profits). Patrizia has sold down almost all of their development and co-investment assets except Dawonia. For almost 50 billion AUM, their co-investments from the balance sheet is less than 50 million. 

On incremental AUM’s, Patrizia will be able to earn 20 bps per year without any capital tied up. This will enable healthy growth in profitability with high ROE’s, if the management is able to grow its AUM to 80 billion Euros as it wishes to in the next 3 years. 

Dawonia portfolio, which is the last large balance sheet asset, can be sold down at the current market value to release over 500 million Euros of capital. The end date for this co-investment portfolio is 2023. With the current market conditions, most investors would want to HOLD on to the portfolio and thus extend the fund life. Even on extension, there could be a technical trigger of exit which can potentially release capital next year (at least on the 350 million of performance fee claims). This can be a large catalyst to the share price, but there is no clear clarity on the same. 

5.) Cheap Valuations:

The current market cap of Patrizia is 816 million Euros. The net cash on the firm's balance sheet is around 220 million Euros. We may want to reduce another 100 million Euros as there is an acquisition related earn-out next year. Their co-investment portfolio (primarily Dawonia) is worth 595 million Euros. Hence, there is a balance sheet value of 715 million Euros. 

Hence, the asset management business with 56 billion of AUM is available for less than 100 million Euro valuation (20 bps of AUM) which is several times cheaper than private market transactions in the alternate asset management space. 

Dawonia is a solid Munich residential real estate portfolio that is currently marked at a 3%+ rental yield. With increasing cost of construction and under supply in Munich, there should not be any big mark down in this value. It has low leverage and can pass on indexed rent inflation. 

In a bad macro scenario, I believe that we can discount 15% of the current value for Patrizia’s direct stake in Dawonia (182 million Euros) and discount at 30% for the accrued carry on the balance sheet (355 million Euros). Even in this scenario, the on-balance sheet value for Patrizia would be 510 million Euros and hence the asset management business with 50+ billion AUM is available for 300 million Euros (50 bps of AUM). 

Even on traditional metrics, the P/B is 0.6X, tangible P/B is 1X (even while considering 117 million Euros of deferred tax liabilities), EV/ EBITDA is 8X (in a tough year) and dividend yield is 3.3%. Even though we await markets to value them as an alternate asset manager, there is strong downside protection due to the solid asset base. 

Once the current bearish sentiment around Europe turns around, I believe Patrizia's shareholder returns will come from all the 3 levers - revenue growth, margin expansion and valuation re-rating. Thus the Risk-Reward is extremely asymmetric for an investor at the current share price.  

Why is the stock cheap?

Almost 80%+ of Patrizia shareholder base is from Germany. Patrizia share price has an almost 1:1 co-relation with German residential REIT’s which have LTV’s of almost 50%. I believe that the German investor base doesn’t have a good asset management business comparable to Patrizia as there are no asset management peers and hence is bracketing the firm with peers who have a very different business model. 

Potential Risks:

Patrizia has historically evolved from acting as a transaction manager for institutional investors to a fund model. Hence, unlike other scaled up asset management firms like Blackstone, Patrizia has an inefficient revenue and cost structure. They manage their 55 billion AUM across 146 funds and only the recent few are 1 billion+ vehicles with better economics. The older vehicles have a structurally lower margin profile. Transaction and Management fees are grouped together as a recurring revenue stream only in the new fund vehicles. Hence, there will always be a valuation multiple difference versus alternate asset management peers. 

Despite the very attractive valuations and cash on the balance sheet, Patrizia’s management is buying back shares only at a very slow pace, spending just 30 million Euros on buyback (3%+ of existing market cap). Management believes that they would always like to stay public as there are huge benefits of being a listed firm when scaling up their asset management business. With the owner-operator continuing to own 54%, they don’t want their buyback to shrink the float even further. This clearly takes away the easiest catalyst, of the firm retiring 20%+ of their shares at current prices and creating value.   

In my view, management has historically acquired smaller asset management firms at slightly elevated multiples (12.5% ROCE) to help them diversify their business. Patrizia has gone into non-German real estate, Infrastructure funds, real estate credit funds etc. They need to execute well and prove that these diversifications can be successful as I don’t see any clear ‘Right to Win’ for their business outside the core European real estate asset class. 

Conclusion:

If there is financial repression (holding interest rates below inflation for a prolonged period) due to unsustainable levels of debt in the developed world, I believe that real estate as an asset class at the very least will continue to hold on to its purchasing power and thus continue to get strong institutional flows. The demand-supply dynamics of increasing urbanization (+ immigration) combined with increased construction costs will provide inflation protection to good properties in European cities. 

With EUR 16.9bn equity raised over the past 10 years, PATRIZIA is the second most successful fundraiser globally for Europe-focused Private Real Estate Funds. Even in 2021, they raised 2.1 billion Euros. Thus the platform is well positioned to profit from increased allocation to real assets. Even if there is no incremental fund raise, their existing base of assets will continue to provide fee generation opportunities for the next decade. 

European equities and assets are currently out of favour and that provides us attractive valuations to buy into a good firm like Patrizia at distressed valuations. I believe that Patrizia is a defensive stock to own during a period of great macro uncertainty as their solid balance sheet and perpetual fee earning funds provide downside protection and visibility to earnings. The bet is asymmetric as there could be meaningful upside if the firm continues to grow its earnings and markets re-rate it as a capital light compounder with recurring earnings. 

Catalyst

Dawonia - Crystallization of carry