Disclosure: No positions in stocks mentioned
Publicly traded private equity firms KKR & Co. (KKR), The Blackstone Group (BX) and Apollo Global Management (APO) declined more than the overall financial sector during the 3rd quarter (1). It appears that investors had concerns that these firms would suffer from liquidity drying up in the financial markets and hurt values realized on their existing investments. I believe private equity firms’ business franchises don’t change in value as much as the volatility of their stock prices would predict. When these firms’ stocks sell-off on fears that their existing portfolios are declining in value, I believe there is a opportunity in their stocks.
The Blackstone Group has proven to be a volatile stock. BX opened for trading at $36.60 on June 22, 2007. Less than 2 years later, it had fallen 90% when it hit $3.55 intra-day on February 27, 2009. BX then climbed 450% to a recent high of $19.49 in April 2011. Since April, it has declined another 43% on the broader market sell-off. (Source: Bigcharts)
During this time, I would argue that the value of Blackstone’s business franchise has not been nearly as volatile as the stock price. Here’s a chart showing Blackstone’s fee-paying assets under management since coming public. As you can see, Blackstone’s assets under management have increased 76% since coming public in 2007 with little volatility.
I would argue that investors place too high a value on the immediate prospects for exiting the firms’ current investments. While exiting investments and recording incentive fees on these investments is an important part of the income stream, there are times when these stocks sell off to such low levels that they are good values, even ignoring any future incentive fees. Currently, Blackstone trades at 15x the 2012 estimates made by Oppenheimer analyst Chris Kotowski for Blackstone’s earnings only from its management fees. At its February 2009 lows, Blackstone traded at just 9x its 2009 management fee-only earnings. (Source: Oppenheim note 9/6/11 “Resetting for the New World Order”)
In thinking about a private equity firm’s business franchise, I believe the value of the firm lies in its ability to continue to raise additional funds from investors. This fund raising ability is affected by past absolute and relative performance of its investments, its reputation, and its personal relationships with its clients. When the stock market declines, only the absolute performance of a private equity firm’s investments declines, but it does not quickly affect the other factors that predict a private equity firm’s fund raising ability. Blackstone has demonstrated a strong ability to raise assets since coming public. I would argue that its ability to raise assets demonstrates its business franchise has increased in value.
The other part of investing in private equity firms that is often missed in stock market declines is the increased investment opportunities these firms have. Unlike their investment banking peers, when liquidity gets tight, private equity firms have dry powder to make new investments. Plus, they do not become forced sellers like Bank of America was in selling its private equity stake in HCA a few weeks ago. Of course, private equity firms may not be able to use as much leverage as they could in a more liquid capital markets environment, however the declines in investment prices may offset the lack of leverage in these new investments.
The current sell-off in the stock market is presenting a second opportunity to buy the publicly traded private equity firms. I believe the stocks of these firms are more volatile than the underlying business franchises. The volatility comes from investors focusing on realizing value from the firms’ existing portfolios. Instead, I’ll focus on the private equity firms’ ongoing franchise values as measured by their ability to raise money for new funds they offer.
(1) In 3Q 2011, KKR declined 36.27%, BX declined 27.66%, APO declined 40.46%, and the XLF declined 23.06% (Yahoo Finance)