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By Matthew Coffina, CFA | 09-04-2014 06:00 PM

How Alternative Asset Managers Make Moats

Oaktree, Apollo Global Management, and Blackstone have built competitive advantages out of strong brands and explicit switching costs, says Morningstar's Matt Coffina.

Jeremy Glaser: For Morningstar, I'm Jeremy Glaser. We recently initiated coverage of a number of alternative asset managers and found that many of them do possess economic moats. I'm here today with Matt Coffina--he's the editor of Morningstar StockInvestor newsletter--for an overview of the category, a discussion of why they have moats, and a look to see if any of them look attractive today.

Matt, thanks for joining me.

Matt Coffina: Thanks for having me, Jeremy.

Glaser: Let's talk about what these alternative asset managers are. How do these businesses operate? How do they make money and how is it different from a traditional asset manager that investors may be more familiar with?

Coffina: Alternative asset manager is really a broad term that applies to any number of firms that manage money primarily for institutions investing in alternative asset classes--things like private equity, hedge funds, real estate, and so on.

The way that they make money is, first, they charge a management fee, which is a percentage of the assets under management. Second, they charge performance fees, and this is typically the largest component of their revenue. They'll get some percentage of the returns earned by the funds that they're managing, usually above some kind of hurdle rate. So, say, after an 8% hurdle rate, the fund company is entitled to 20% of the profits from a given fund. Then lastly, they also earn investment income, so they normally invest some percentage of the capital in their own funds. And as investors in those funds, they're earning investment returns alongside the third-party investors.

So, again, the typical investors in these kinds of products would be institutions, like pension funds or endowments--although companies are increasingly moving into individual retirement products in particular, either launching closed-end funds or even traditional mutual funds, targeting that very large pool of assets that is individual retail investors.

Glaser: But why do these businesses have competitive advantages? What stops other companies from maybe offering similar products? What keeps these firms on top?

Coffina: With traditional asset managers, we usually think of the two main sources of advantage being intangible assets. People don't want to give their money to just anybody; they want to give it to a firm that has a good reputation that they believe is going to manage risk appropriately and is going to earn solid returns over time.

And secondly, switching costs: So, assets tend to be relatively sticky at traditional asset managers. Once people invest in a given fund, they're usually reluctant to move their money around because the payoff of doing so can be so uncertain. Even if your fund underperforms, unless you want to chase performance and just go after the next hot fund (which studies have shown is frequently not going to be the best performing fund in the future), the payoff of switching funds is usually so uncertain that investors don't do it all that often. With alternative asset managers, I think you can make the case that these sources of competitive advantage are even stronger.

So, when it comes to intangible assets, institutions are even more picky about whom they're going to invest their money with and, in particular, a lot of these funds have these lockup periods, which could be 10 years or more when you're not allowed to remove your money from the fund. So, you're going to have to be very certain that you trust whomever you are giving your money to, if you are giving it up for 10 years without being able to withdraw.

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