A Deeply Undervalued Asset Manager

After incorporating the impact of the AR Global transaction and our revised forecast for incentive income, we lowered our fair value estimate for

We do consider the AR Global transaction a positive, as we estimate it has added $1-$2 to our fair value estimate. We forecast that the deal will take Apollo's real estate fee-earning assets under management to $48 billion in 2019 from $11 billion in our prior forecast, which is made up of the $12 billion in initial AUM acquired plus an incremental $23 billion of inflows over 2017-19. Similarly, segment economic net income increases to $185 million in 2019 versus $53 million in our previous forecast, reflecting an incremental $0.32 per unit in earnings. While the management realization rate for AR Global assets is decent, at 80 basis points by our estimates, AR Global also earns advisory and carried interest from its business development companies. The BDC fees are typically based on asset size, creating stability but also letting Apollo benefit from asset growth over time. We consider the stream of income highly stable, helping offset Apollo's still sizable contributions from its more volatile and mature private equity AUM. We continue to believe Apollo is quite well positioned to drive incremental AUM inflows, given its leading retail platform, especially if it pursues product step-outs under its own brand name rather than the tarnished American Realty brand name.

Virtually the entire decline in our fair value estimate came from changes to our forecast for incentive income, particularly in the later years of our explicit five-year forecast period. We also sharply reduced the contributions from advisory, monitoring, and transaction fees across the credit and private equity segments to $65 million from $359 million in 2019, reflecting the fact that future limited partner agreements are likely to be far more transparent around these types of fees, rebating all of them to limited partners or eliminating them entirely. The changes to our incentive income forecast are primarily in private equity, where our 2019 forecast for realized incentive income is now around $875 million versus $1.5 billion in our prior projection.

The rationale behind this change in our incentive income forecast is considering changes in the levels of carry-eligible and carry-generating AUM in private equity and the expected correlation with Apollo's ability to generate realized incentive income in the near and long term. For context, private equity carry-eligible and carry-generating AUM was around $38 billion and $32 billion in early 2013, respectively, and both metrics now stand at $34 billion and $12.5 billion today. As Apollo generates realizations through sales of assets, such as the $2.1 billion in realized gains from the second quarter of 2013 to the first quarter of 2014, this represents an estimated $10 billion-$12 billion in assets departing the portfolio that needs to be replenished with newly successful investments. Replacing these assets is roughly three to four years of investments at Apollo's current $3 billion-$4 billion annual deployment pace, or roughly two years of investments if Apollo can quickly generate a 2 times multiple of invested capital. We would also expect existing portfolio investments to increase in value over time, contributing to gains in carry-eligible and carry-generating AUM as we don't think Apollo's strong record is diminished. We forecast Apollo's fee-earning private equity AUM to be around $48 billion in 2019 versus $39 billion at the end of 2015, so we don't expect meaningful increases to the carry pools from growth in the largely mature space. As it will take a while for Apollo to rebuild its carry-generating pools through solid investments, and we don't expect the carry pool (around $30 billion) to be meaningfully larger than 2013-14 levels over the next few years, we have resized our realizations forecast appropriately.

Look Past the Headlines We still consider Apollo to be deeply undervalued, however. The industry is still mired in a negative new flows cycle, with headlines on taxes, KKR's $30 million settlement with the Securities and Exchange Commission, and limited partner pressure for additional disclosure. The industry is struggling to put money to work in a high-valuation environment, and mark-to-market losses in the energy and credit portfolios have hurt recent earnings results.

We encourage investors to look past the headlines and consider the long-term view as well as the quality of the Apollo franchise. We project Apollo to generate around $1 billion in distributable earnings in 2016, meaning at $20 per unit, Apollo trades at less than 10 times our forecast of 2016 cash earnings and around a 10% distribution yield. As well, we expect that Apollo will generate around $300 million in high-quality management fee net income in 2016. At a 15 times multiple, we estimate this stream of income is worth about $4.5 billion. In turn, we expect realized gains in private equity and credit to improve in 2016 to $1,175 million from 2015's $825 million. After compensation, we expect around $650 million in profitability contributions here, and the market is valuing this high-quality stream of cash earnings at just 5-6 times earnings. These numbers ignore the noise over mark-to-market gains and losses, which are noncash and contribute to economic net income, and thus better serve to illustrate the value of Apollo, in our view.

Positioned for Lucrative Returns Apollo Global Management's specialization in illiquid credit instruments offers substantial potential in the coming years. Banks of all sizes, under tough regulatory scrutiny following the Great Recession, are shedding risky and complex credit assets to shore up their capital ratios. We see this as a secular trend, particularly as regulatory rules force banks to shed risk, and Apollo's relationships and deep expertise in the market position the firm to earn lucrative returns.

The acquisition of fixed-annuity provider Athene differentiates Apollo from its peers, in our view. Apollo's permanent capital base with Athene is just over $60 billion in assets under management, almost 40% of Apollo's overall AUM. Apollo has further bolstered its permanent capital base of AUM with the acquisition of AR Global, which adds $19 billion in primarily real estate permanent capital vehicles. Unlike private equity funds, which have a life cycle of 10-11 years, Athene's and AR Global's AUM does not need to be returned to investors, meaning that Apollo can earn steadily greater fees as the asset bases increase over time and as it invests more of Athene's AUM in Apollo funds. Furthermore, there is substantial opportunity to reposition Athene AUM toward the type of illiquid credit investments that Apollo has been buying up in its own funds, boosting Athene's returns and, more important, generating capital to be used for further acquisitions of insurance float (and thus Apollo AUM). Finally, as Athene is a fixed-annuity provider, its costs are generally fixed, while Apollo's investments for Athene are generally in variable-interest securities, meaning it should benefit from higher interest rates through a wider spread.

While we see Apollo's largest opportunity in credit in the coming years, its highly respected private equity business should still do well. In 2013, Apollo raised the industry's largest fund ever, Fund VIII, with $17.5 billion from outside investors in just 10 months. In mid-2015, the fund is about 31% deployed, and we think it will serve as the base for future Apollo realizations over the coming years.

Sticky Assets Make a Moat We believe Apollo has earned a narrow moat. Traditional asset managers typically benefit from intangible assets and switching costs as moat sources in the form of substantial reputation benefits as well as sticky assets. We think alternative asset managers like Apollo benefit even more than traditional asset managers from these sources, given the less transparent nature of the lucrative returns they earn, as the vast majority of Apollo's investments are typically in nonpublic assets. These assets tend to be stickier than traditional assets, as private equity funds typically have 10- to 11-year lockup periods, meaning investors see a return of capital only when an investment is realized, which is at Apollo's discretion. While absolute investor costs for switching asset managers tend to be small, investors tend to stay with managers because of inertia. Performance certainly helps, and Apollo's internal rates of return across its major private equity funds are around 25% over 20 years. Institutional investors (nearly 80% of industry AUM) also prefer to invest in established managers, and an estimated 90% of industry asset flows go to funds with assets over $1 billion. Finally, with Athene's AUM making up 40% of overall AUM (and AR Global boosting the percentage to just over 50%), Apollo has a large source of permanent AUM (Apollo's contract to manage Athene's AUM can technically be terminated, but as Apollo has substantial influence over the AP Alternative Assets entity that owns Athene, we see this as extremely unlikely), from which it can extract fees consistently over time.

Lack of Liquidity Is a Risk, but Part of the Plan Apollo's private equity and real estate investments are highly illiquid. Indeed, this illiquidity and associated complexity is a core part of Apollo's investment approach. Tightened credit conditions could limit the firm's ability to move into new investments (though it has invested 40% of its funds in a down market), while weak economic conditions and difficult equity and credit markets could affect not only the value of Apollo's investments, but also its ability to cash out. The firm's investments in real estate also subject it to the risks inherent in the ownership and operation of real estate and related businesses and assets. With incentive and transaction fees accounting for a significant portion of annual revenue, the volatility inherent in these types of fees can have a major impact on the firm. Our fair value estimate anticipates steady fees across Apollo's funds, so it may be too high if fees fall. More important, poor investment performance not only affects revenue, profitability, and cash flows, but also could obligate the firm to repay carried interest earned in prior periods and potentially have a negative impact on the company's ability to raise new capital for future investment funds. Limited partners typically use distributions from funds as new capital commitments for new funds. Any financial stress experienced by the firm would be further compounded by the fact that Apollo has taken on a fair amount of debt via a credit facility during the past few years.

Apollo's business model depends heavily on having fully functioning credit and equity markets that will allow its investment funds to not only arrange financing for leveraged buyouts, and the companies it operates, but cash out of them once they've run their course. That said, we see Apollo as prudently leveraged for its business model. In mid-2015, Apollo has $800 million in cash versus $1 billion in debt, which is primarily a credit facility that matures in 2019. Apollo has another $500 million available on an undrawn revolver. We estimate that Apollo's financial metrics are healthy, as distributable earnings should cover interest more than 30 times. It should also be noted that there has been growing support for greater regulatory oversight of private equity and hedge funds, as well as calls for higher taxation on carried interest, which could undermine aspects of the business model that Apollo currently employs.