Description

Long AAA NA: AP Alternative Assets (“AAA”) has units that trade OTC in the USA under the symbol APLVF, but the company's units primarily trade in Amsterdam under the symbol AAA NA.

Write-up with graphics is posted in below link:

https://drive.google.com/file/d/0ByBNCkJEkQSDZUZqRmd6LTZQTFE/edit?usp=sharing

Situation Overview

AP Alternative Assets has been written up before on VIC, but I thought I’d provide my own update, as I think the risk-reward at the moment is particularly attractive. I’ll provide a preliminary overview here, but please refer to the previous write-ups for further context.

AP Alternative Assets (AAA) is an Apollo-managed closed-end fund based in Guernsey which was set up originally as a vehicle enabling retail investors to indirectly participate in Apollo private equity and other alternative asset funds (AAA collects an annual management fee and 20% carry). In late 2009, Apollo hired former SunAmerica President Jim Belardi, and with capital provided by AAA, founded Athene as a fixed annuity permanent capital vehicle. Fixed annuities, which provide long-term, sticky, fee-generating capital, are an ideal source of investable funds (i.e., AUM for Apollo). Jim Belardi is a renowned insurance company executive. While at SunAmerica in the 1990s, the stock was the best performer on the NYSE, appreciating 213x and eventually being sold to AIG for 6.6x book value. In 2011, AAA contributed substantially all of its assets into Athene in exchange for more equity (effectively making AAA a look-through share of Athene, though annoyingly burdened with management fees and carried interest).  Since 2010, Athene has acquired four major fixed annuities businesses: Liberty Life (2010), Presidential Life (2011), Investors Insurance (2011) and Aviva USA (2013).

At the time of the previous write-ups, the Aviva acquisition ($45bn in assets, 3x the then-size of Athene) was pending and undergoing various regulatory reviews.  The acquisition closed in October 2013 and, since then, Athene has been undergoing a complex integration process. In addition to closing the Aviva acquisition, Athene announced an additional capital raise of $1.3bn that was completed this summer at $26 per Athene share (~$29.50 per AAA share; ~$27.90 per AAA share after APO carry). The proceeds of the offering will be used to shore-up Athene’s capital base in order to obtain a credit rating upgrade, as well as possibly be used as dry power for future M&A.

Athene represents a compelling opportunity on both an absolute and relative valuation basis. The current opportunity exists for a number of reasons including: no research coverage, small and illiquid float, complex situation, and limited financial disclosures.  All of these issues will disappear when Athene goes public, likely in 2015. 

Based on my estimate of normalized earnings and a below-peers P/E of 10x, I believe that AAA is worth $45.00 per share (~41% appreciation).  My upside case (50% of equity raise is used for another acquisition that yields a 20% ROE) and 11x P/E (in-line with comps), AAA is worth $53.50 per share (~67% appreciation from current).

Background / Business Model

A fixed annuity company can be conceptualized as a “net spread” business; it borrows in the form of annuities (either traditional fixed or fixed index) at a very low cost for long durations (protected by surrender charges), and invests the proceeds in primarily investment-grade credit assets. Products are typically marketed to individuals (i.e., retirees) by independent marketing organizations (IMOs) where insurance agents receive hefty commissions. The industry is fairly competitive and through-cycle ROE is in the low teens (~10-13%).  In addition, fixed annuity businesses require high amounts of leverage (typically in excess of ~10:1 assets-to-equity).

Athene was founded in 2009, which fortuitously happened to coincide with a global regulatory push, in Europe in particular, where financial institutions were forced to raise capital, which resulted in a lot of companies in the fixed annuity business being sold at the same time (Fidelity & Guaranty sold by Old Mutual plc, Liberty sold by RBC, Aviva USA sold by Aviva plc, EquiTrust sold by FBL). This created an excellent buying opportunity for private equity players like Apollo and Guggenheim, which have been particularly aggressive over the last few years in assembling fixed annuity platforms.

Athene has been very successful in aggregating and consolidating four fixed annuities businesses under a world-class management team and is pursuing a strategy not too dissimilar from Warren Buffett’s Berkshire: find a platform that creates extremely low cost, long-term, sticky liabilities (“float”) and on the asset side, strategically invest in assets with higher yields (typically fixed income with a small alternatives allocation). Because of the long duration and sticky nature of Athene’s liabilities, it does not need to buy assets with CUSIPs (i.e., liquid assets). It is built to handle illiquidity and Athene’s current strategy is to redeploy Aviva’s acquired assets (investment-grade CUSIP bonds), into products that have “more value” such as investment-grade non CUSIP securities (Apollo’s Mark Rowan explains, see below).

“And I'll give you one example, just to capture the imagination on dislocation. We look at -- we have a very good practice in insurance. And we will not surprise you, we're big investors in insurance-linked securities. So you take a typical insurer like Aegon or ING, who are investment-grade issuers whose investment-grade holding company paper trades in the 3s. Their more highly-rated, structurally senior, more complex, less liquid investment-grade securities can yield 6% or 7% in the same issuer. I can earn almost twice the return with less risk by moving down the liquidity spectrum. For an account like Athene, that is an ideal situation. And what I like is, on the one hand, Athene's liabilities are priced relative to investment alternatives available to consumers, think CDs. So rates are very, very low. On the other hand, their assets don't have to be liquid, but they do have to be highly rated. And this bank cycle, this bank rotation that I've been talking about, is a source of tremendous amount of products for the Athene to the world, as well as for our pension fund clients. And I do think that's the biggest opportunity in front of us. It is not the alternative credit opportunity.” – Mark Rowan at the GS Financial Services Conference in December 2013

In addition to strategic asset allocation, Athene is structured to be highly tax efficient (more on that later) and will reap large cost synergies by consolidating headcount and office locations of acquired platforms. To sum it up: Athene has successfully become one of the largest and most profitable players in the fixed annuity industry by acquiring inefficient, undermanaged operators and more opportunistic M&A is almost sure to follow.

For an overview of Athene’s business model, check out the below presentations on AAA’s website:

Original Athene Presentation – contains investment thesis and high-level unit economics

http://www.apolloalternativeassets.com/ViewDocument.aspx?f=MHAR_AAA_Presentation_2_6_13.pdf

Update post Aviva-closing

http://www.apolloalternativeassets.com/ViewDocument.aspx?f=TLJU_Information_for_AAA_Investors_on_Athene_(March%202014).pdf

Latest

http://www.apolloalternativeassets.com/ViewDocument.aspx?f=GOVC_Information_for_AAA_Investors_on_Athene_(June2014).pdf

AAA Update / Investment Catalyst

The previous VIC write-ups focused on closing the Aviva acquisition as a catalyst.  The acquisition closed about a year ago but AAA’s unit price has not moved much (up ~15%).  I think the reason why the price has stagnated is due to the primary equity offering that was announced in January 2014 (originally $500mm, but expanded to $1.3bn).  This offering was highly dilutive to existing Athene shareholders (AAA in particular), especially if you assume none of the capital will be deployed in a value-enhancing acquisition. Despite this ostensible per-share value destruction, I think Athene (via AAA) represents a compelling investment opportunity. I believe that an IPO is imminent (probably mid 2015) and that the true earnings power of the business will be fully revealed at that time. In addition, although the equity raise was dilutive, the much stronger capital position should provide Athene a more attractive IPO valuation and give the company flexibility should opportunistic M&A arise.

The pre-IPO capital raise (~$1.3bn) was 20% funded in Q2 2014 and will be fully drawn within 12 months of initial closing in April 2014. Management has stated that the capital raise is meant to strengthen the company’s balance sheet, give it flexibility in pursuing additional strategic M&A, and achieve a ratings upgrade.  In particular, an AM Best upgrade from B++ to A- (“Good” to “Excellent”) would likely open up new distribution channels that Aviva had access to prior to its acquisition by Athene. Note that Aviva’s closest competitor Fidelity & Guaranty (NASDAQ:FGL) also has a B++ rating.

Delayed Release of Financial Results

Athene typically releases its quarterly financial results to AAA unitholders ~6 weeks after the end of the quarter, but Q2 2014 results have been delayed in order to remediate “material weaknesses in internal controls.” At face value, this sounds really bad, but keep in mind Athene is a private company and Aviva was not a GAAP filer.  In the context of a private company in the process of preparing for an IPO and implementing public company, SOX compliant standards, I don’t think this is a huge risk factor.  Athene received a clean 2013 audit, but was notified of material weaknesses in controls (all previously disclosed in early 2014), which the company has been addressing.  See below commentary from the Q1 ’14 earnings call.

“So we're using this integration as an opportunity to upgrade the combined accounting systems with a goal of being able to meet public company reporting requirements before the end of 2014. We're on track to meet that goal. However, even though Athene received the clean audit opinion for its 2013 statements, did inherit two material weaknesses in control, one for reserves and one for taxes. We do have a plan in place to remediate both of those deficiencies in 2014.”

Athene has made accounting restatements before, so this is nothing new. I think the most likely reason for the delay is to allow for the final closing of the primary equity offering at the (undervalued) current Apollo mark on Athene. If Athene releases good results and provides more color on IPO timing, it could result in a rally in AAA unit price which could potentially complicate its final equity raise closing (which is Athene employees and “affiliates” (i.e., Apollo), so it’s not as if they are incentivized to get the best price).  Lastly, I would note that Athene’s investment assets are disclosed in APO’s public filings and AUM was at $61.0bn on June 30, 2014 (up from $59.2bn on March 31, 2014). This is significant since only 20% of the initial closing commitment had been drawn (~$200mm), which implies organic investment asset growth in the quarter of ~$1.6bn (~11% annualized asset growth).

Investment Thesis

• World-class management team.  Jim Belardi led Sun America through the 1990s and built one of the most successful retirement services companies in the US (in 1998 Sun America was acquired by AIG and is currently part of AIG Retirement Services). Athene’s management team is highly focused on risk management (they duration and maturity match, unlike some competitors) and they take no foreign currency risk. The following comment from Jim Belardi in November 2013 summarizes the company’s philosophy: “We are not volume driven. We will only add business if it meets our return objectives, whether that’s in the retail space, in the institutional space or in M&A activity. If we can’t make our returns, we won’t do it.” This comment is consistent with the company’s track record.  Annuity sales are down vs. pre-Aviva peak, but profitability (as measured by ROE) is by far the highest in the industry.
• Athene is a tax inversion play.  I have not seen this mentioned in other write-ups or by Athene’s management team (other than very high level “our corporate structure brings efficiency on tax”), but I believe one of Athene’s largest advantages is its tax structure. Because Athene Holding Ltd is domiciled in Bermuda and a Bermuda subsidiary (Athene Life Re) reinsures a substantial portion (~80%) of all in-force and new business, Athene’s effective tax rate is much lower than its US-based competitors (2013 tax rate: 5.8%; 2012 tax rate: -3.7%).  The favorable tax position will support the above industry average ROE target in the management presentation, as well as provide the company a cost advantage in writing new business. In my base case, I’ve assumed a 10% effective tax rate (which implies 25% of pre-tax income is US-based and taxed at a 40% rate; Bermuda has no income tax). Assuming US peers generate a through-cycle ROE of ~11.5% (consistent with history), the pre-tax industry ROE would be ~19.2% and Athene’s through-cycle ROE (at 10% tax rate) would be ~17.3%, consistent with “high teens run-rate ROE” commentary from management. Athene is a highly attractive investment due to its ability to sustainably compound capital at mid-teens returns due to its structural tax efficiency relative to the industry.  Athene has not provided guidance on its future tax rate, but has stated that “Over time, the business mix between Athene’s U.S. subsidiaries and Athene’s Bermuda subsidiary will determine the blended tax rate reported in Athene’s financials.”
• No research coverage. Limited liquidity.  The opportunity exists because (i) limited liquidity suppresses hedge fund involvement, (ii) no research coverage results in limited retail investor interest and (iii) the situation is complex, the life insurance industry is characterized by arcane accounting policies and management has been non-transparent in its investor disclosures.
• IPO as catalyst.  There is a high likelihood that Athene will IPO in 12-18 months. The company has stated its intent to IPO many times, including in disclosures to regulators. Upon IPO, there will be a lock-up on AAA shares for 7.5 months, after which AAA will commence a wind-up tender offer. Unitholders that do not tender will receive a distribution of their pro rata portion of common shares of Athene as such shares are released from contractual lock-up over a period of 7.5-15 months following Athene’s IPO. It is important to note that AAA will remain a publicly-traded vehicle after the IPO (and until wind-up), so AAA investors will continue to have liquidity despite the lock-up.
• Favorable demographic trend.  Demographics and macroeconomic factors are increasing the demand for FIA products, for which demand is large and growing: over 10,000 people will turn 65 each day in the United States over the next 15 years. According to the U.S. Census Bureau, the proportion of the U.S. population over the age of 65 is expected to grow from 14.8% in 2015 to 20.3% in 2030. Due to turbulence in the stock market in 2007 and 2008, many middle-income Americans have grown to appreciate the security these indexed products afford. As a result, the FIA market grew from nearly $12 billion of sales in 2002 to $34 billion of sales in 2012.
• Long-term compounder.  Athene’s management team is positioning Athene to be one of the largest and most profitable retirement services companies in the US.  Management is in the process of redeploying the ~$45bn of assets acquired from Aviva into higher-yielding assets and increasing portfolio yield (which flows directly to the bottom line; I have assumed no additional redeployment in the base case, other than investment of excess cash). In addition, Athene is growing its reserves through issuance of new annuity policies (target is ~$3bn of annuity sales this year), and sales will rise further if Athene receives a ratings upgrade, which provides access to additional distribution channels. Prior to the Aviva acquisition, Aviva USA was writing ~$4bn of FIAs per year with #2 market share in 2012 and 2011 (vs. #5 currently). The most recent data is highly encouraging: industry-wide FIA sales were up 37% YoY in Q2 2014 (and up ~9% vs. the previous record quarter which was Q4 2013). Increasing annuity sales provide Athene the opportunity to compound internally generated cash flow at attractive high-teens returns.  Although I anticipate Athene’s ROE to gradually decline from low 20s currently (largely a result of attractive acquisitions) to mid-to-high teens (run-rate on new business), this will happen over the course of several years and the growth in Athene’s book value will more than offset the decline in P/BV multiple that results from lower ROE over time. Jim Belardi summarized the long-term thesis well in Athene’s Q3 2013 conference call: “We do now have in place the infrastructure, the cost structure, [and] the man power to take advantage of exactly how this business was designed, which is to add significant amount of additional business with little incremental variable cost.”
• Management and Apollo are investing heavily near current price.  Management and Apollo have participated heavily in the latest equity raise for Athene investing a combined $230mm (18% of $1.3bn total). At the per share value of Athene of $26, on a look-through basis to AAA the value is $29.46 ($27.87 net of carry) per unit compared to a trading price of $31.99 currently.  This means that investors in AAA are paying a 8.6% premium (15% net) to insiders, but the premium implicit in AAA units is partially justifiable given the enhanced liquidity profile. In addition, I think the $26 price per Athene share is far too cheap, as it implies only 5.7x my normalized earnings estimate of ~$4.50 per Athene share.

Investment Risks

• Monoline business. Athene’s lack of diversification (heavily concentrated in fixed index annuities) is a risk as it exposes the company to adverse legislation or regulatory developments around the FIA space (which has had a history of controversy). The Harkin Amendment (passed in 2010) bans the SEC from regulating FIAs, which largely mitigates this risk.
• Credit risk.  Given Athene’s high leverage level at 15.5x investments/equity (ex-AOCI), the company is particularly sensitive to credit events. Notwithstanding, Athene’s leverage is not crazy in comparison to its closest publically-traded comps (FGL at 14.1x and AEL at 24.4x investment assets /equity (ex-AOCI)).  Although Athene has a relatively aggressive asset allocation (with 7% of assets invested in alternatives), its RBC was 478% at year-end 2013 vs. 501% for FGL, 344% for AEL, and 458% for SYA.
• Adverse tax ruling / legislation.  If the IRS or congress were to challenge Athene’s current structure, the pro forma tax rate would be significantly higher than today’s. Although there have been recent legislative proposals to close this “loophole”, I think it’s unlikely anything gets done outside the context of overall corporate tax reform. Looking at statistics on the percentage of bills that go from introduction to passage, the record is about ~2-3%. Of the ~9,700 bills introduced in the 113^thCongress, only about 1.75% became law.  Of the~170 bills that became law, only 2 of those involved taxation (both introduced by Republicans).
• Athene Asset Management (AAM) is not owned by Athene.  AAM which manages 100% of Athene’s assets is owned and consolidated by Apollo (including Athene management).  AAM charges an annual fee of 40bps on all AUM it manages, which in this industry is an enormous sum and represents a drag on ROE of 5.4% annually (40bps*(1-10% tax rate)*assets/equity of ~15x).  AAM also allocates a portion of AUM to Apollo funds (as of 6/30/14, 17% was sub-advised by Apollo), and from which additional fees are levied.  Perhaps after the IPO, Athene’s shareholder base will broaden and investors will demand better terms from Apollo.  Notwithstanding, it’s hard to argue that AAM and Apollo have not added significant value to Athene, despite the high fees.  The best managers are never cheap but often worth paying for. 

Valuation & Returns

Current Valuation / Apollo Mark

Athene shares are currently marked at $26.00 per share by Apollo (based on the most recent capital raise). This price implies a P/E of 5.7x my normalized earnings estimate, 1.22x P/GAAP BV (ex-AOCI, pro forma for capital raise), and 0.78x P/Stat BV (pro forma for capital raise). P-GAAP life insurance accounting is highly complex.  At a very high level, in P-GAAP accounting, both assets and liabilities are marked to FV in an acquisition, whereas in stat accounting, assets are marked to FV, but liabilities are marked at actuarial value.  This creates a large, but temporary delta in stat and GAAP book value.  Athene management explains, “the gap between statutory capital and GAAP book value is expected to appreciably narrow over time as GAAP book value approaches statutory capital.” Hence, I think it’s important to think about valuation from both a GAAP and stat perspective.  I included a deeper discussion of this in the appendix¹.

Normalized Earnings

My base case takes Athene’s latest management-adjusted quarterly results (Q1 2014) and annualizes them to come up with a “run rate” earnings forecast. In addition, I make three normalizing adjustments.

1. As of Q1 2014, AAA disclosed a 7% allocation to “Alternatives” with a target yield of 13% (for total exposure of ~$4bn). During the Q1 2014 conference call, management stated that their recurring / non-alternatives investment income for the quarter was $512mm (implying $67mm of investment income from alternatives, or an annualized rate of 6.5% on the $4bn allocation).  Assuming through-cycle Athene can generate a 10% return on its alternatives allocation (vs. 13% target), normalized annual alternatives investment income would be ~$410mm (vs. the $270mm implied by the Q1 ’14 figure).
2. As of Q1 2014, Athene disclosed a cash & equivalents allocation of 5% (~$2.9bn). My base case assumes that $2bn of that cash is deployed into higher yielding assets, consistent with management commentary: “In addition to selling down over time some of the investment grade corporates that we hold, we started the year intentionally with higher than normal cash and we will deploy that cash as well.  So if you look at where the portfolio is on March 31, across time you should see the cash and equivalents continue to get redeployed into our preferred structures and also the investment grade corporates.” I assume that $2bn is redeployed at a 3.5% incremental yield (vs. 3.9% overall portfolio yield) resulting in incremental annual earnings of $70mm.
3. Athene is raising $1,278mm of primary equity (none of which was drawn at March 31, 2014).  Athene will use this capital to achieve a ratings upgrade, and perhaps use a portion of it to fund opportunistic M&A.  In my base case, I have assumed that Athene deploys 80% of the equity raise in its traditional fixed income portfolio and 20% into alternatives (for an all-in yield of 5.2%), resulting in incremental investment income of $66mm. I think this is conservative, as it does not assume that Athene can find an M&A opportunity, despite management’s assertion that one of the purposes of raising the capital is M&A. 

The above adjustments seem reasonable especially in light of commentary on the March 2014 conference call when they stated that Q4 2013 investment income of $663mm was “close to kind of a fixed income run rate going forward.” After making all of the adjustments I highlighted above, my quarterly run-rate figure comes out to only $650mm (and this includes the added benefit of deployment of the equity capital yet to be drawn).

Trading Multiple / Comps

In terms of trading multiple, Athene’s closest comps (in decreasing relevance) are Fidelity & Guaranty (FGL), American Equity (AEL) and Symetra (SYA), which all operate in the fixed annuity space, though SYA has a more diversified business than FGL and AEL. The three companies currently trade at 10.9x and 11.3x, and 12.8x NTM P/E, respectively.  Note that multiples in this space are at high levels relative to history (in 2009, AEL traded at average NTM P/E of 4.0x, and pre-crisis AEL traded in 7.5-9.0x NTM P/E range).  SYA went public in 2010 and since then its average NTM P/E has been 9.4x.  In recent quarters, multiples across the space have increased as the outlook on the retirement services industry has improved. Industry-wide annuity sales are increasing rapidly, ROEs are recovering, and rising rates will increase the appeal of annuity products. The base case assumes a 10.0x NTM P/E for Athene, which is justifiable given the recent capital raise, tax efficient structure, and best-in-class management team.

Base Case

With the normalizing assumptions I’ve made above, assuming a 10% effective tax rate and a P/E of 10.0x applied to earnings of ~$4.50 per Athene share, AAA will be worth ~$45.00 when the company goes public next year (~41% from current).

[See link for graphic]

Upside Case

I believe there is a reasonable probability that Athene completes another acquisition, especially given this is management’s stated strategy and they just raised $1.3bn (vs. $500mm original target).  Assuming the company uses 50% of the equity raise to complete an acquisition with a 20% ROE, and Athene is valued at 11.0x P/E at IPO, AAA shares would be worth ~$53.50 per share (~67% from current). 

[See link or graphic]

Catalyst