|Shares Out. (in M):||441||P/E||0||0|
|Market Cap (in $M):||23,000||P/FCF||0||0|
|Net Debt (in $M):||0||EBIT||0||0|
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Apollo Global Management is still undervalued
It might seem odd to pitch a company whose share price has quadrupled in value in the last four years, is up over 11% year-to-date and is trading on a core p/e multiple of 26x.
But that’s precisely what I am going to do.
Because Apollo Global Management offers the portfolio manager a wonderful hedge for the secular switch into alternatives and low-cost passive investing. A switch that continues to grow, shows no sign of slowing and risks making all of us obsolete. And it’s a wonderful hedge because it pays you a practically guaranteed 18% gross IRR over a five-year period assuming no carried interest is paid out and no value is ever attributed to it.
At today’s share price, Apollo’s true look through p/e multiple is closer to 10.7x and if you look out five years, it’s a very low 5.3x. Assuming 1x book value for Athene and a 6x multiple on the carry income, Apollo’s intrinsic value per share today is just north of $78 – offering 53% upside when you include the dividend. But the beauty about this cigar butt is that unlike numerous others, it actually keeps compounding in value. So even assuming that the gap is never bridged, you still get an 18% gross IRR.
But my bet is that this gap will get bridged considering the number of near-term catalysts on the horizon.
These include Russell 1000 inclusion, the scarcity of ‘safe’ but ‘growing’ dividends, the monetisation of fund 8 including the impending $10bn IPO of Rackspace Technologies, the recent 401k changes initiated by the Trump Administration, an acceleration of planned life insurance block sales and a favourable fundraising and deployment environment for distressed credit (Apollo’s expertise).
So, I implore you to dump the airlines and the cruise ships and tag along on the coattails of an undervalued investing juggernaut that will – in the next ten years – very likely treble its AUM to circa $1 trillion.
The last ten years
Apollo’s is a story of growth. Since its IPO in 2011;
· AUM has grown 4x (21% CAGR).
· FRE revenues have grown 2.63x (13% CAGR).
· Margins have doubled from 28% to 57% (9% CAGR).
· And FRE per share has grown 5x (24% CAGR).
By any yardstick, that’s pretty impressive stuff. But even more impressive is how they’ve done it.
First, management recognised that you risk sacrificing return for scale in a business such as private equity which is why it’s only doubled in the last 8 years ($35bn to $78bn). They made the shrewd decision to diversify and what started as a high-return distressed debt and private equity platform has morphed into something more relevant in today’s investing environment; a broad-based solutions provider. Despite the ‘vulture’ name tag, circa 70% of Apollo’s AUM is now in low yielding (4-6% return) asset categories.
Second, they have done it whilst adhering to the same value-orientated framework that has been the hallmark of their approach since inception in 1991. For example, the creation multiple on their buyout funds (between 5.0-6.5x EBITDA) is still significantly below that of their peers and despite all the negative and mis-leading press around the “junk” on Athene’s balance sheet, it appears to have weathered the crisis pretty well.
Third, they have done it whilst returning the vast majority of their free cash flow to shareholders in the form of dividends ($19 per share) and some share buybacks.
And fourth, they have done it without excessively diluting the share count (5% total increase).
And for the reasons outlined below, I believe that they will at least double AUM and FRE again in the next five years.
When I have read prior posts about the alts, I have always been disappointed by the lack of industry analysis – the type we all get encouraged to do in our value investing classes at business school. I don’t know if that’s down to familiarity or down to something else, but I have felt that the industry tailwinds are so strong that they warrant greater analysis.
Because when you dig into the industry dynamics, the strength and growth and competitive advantage of the larger platforms really begins to shine.
In the last ten years, the industry has benefited from a number of major secular tailwinds.
Broadly, these are as follows;
The global search for yield
The dearth of yield has put enormous pressure on customers (pension funds, retirees, endowments, insurance companies, HNWs etc) because their liabilities keep going up and the return available from traditional fixed income products no longer covers their near-term obligations. Worse, the true extent of this liability mis-match is very likely understated.
For example, a recent paper by Affiliated Managers Group shows that many US pension funds are still assuming discount rates of between 6.00-7.75% which is clearly too high when the 20-year US Treasury bond trades at like 1.2%. So, whilst the official funding rate of pension plans is circa 75%, the unofficial rate is much lower (40-50%).
Trustees know this and are desperate for product to bridge the gap. And they’re buying more and more private credit and private equity products that offer returns ranging from 5-20%.
Regulatory environment, bank deleveraging and bank consolidation have eliminated traditional competition.
There have been two major shifts in the last two decades that has accelerated the trend towards private debt capital.
First, the 1990s saw significant bank consolidation as a number of regional banks were acquired by – or morphed into - national players. Commercial banks have declined in number by 50% since 1998 and the top 25 banks now hold more than 50% of all commercial and industrial loans. As a result of banks getting larger and larger and fewer and fewer, they have gravitated towards serving fewer, but larger customers.
Second, the introduction of regulation post-2008. The Dodd-Frank / Volcker rule, the large bank supplementary leverage ratio, Solvency II and Basel II - these regulations have resulted in banks materially tightening underwriting standards, increasing their capital bases, narrowing their lending products (particularly the financing of illiquid assets) and shedding staff and legacy businesses.
The result of both is a reduced willingness by banks to lend to a subset of the market that really needs it – the SMEs. You can see this in some of the stats. For example, banks’ share of leveraged loans has declined from 52% in the late 90s to 16% now. Today - in the high yield market - only 5% of issuance is in tranche sizes of $300m or less vs 39% in 2004. The same phenomenon has occurred in the leveraged loan market where only 8% of issuance is in tranche sizes of $300m or less vs 38% in 2004. Meanwhile, the average C&I loan amount held by banks has doubled since 2009.
As the traditional sources of finance have retreated, Apollo has filled the void. And with its long-term stable capital, Apollo is a great provider of liquidity to middle-market borrowers.
Another overlooked point of this dynamic is the impact that regulation has on culture. On morale. Do you want to stay at a bank that’s downsizing or join the desk of a credit team at Apollo that’s expanding its range of products to fulfil a customer need?
I know which of the two I would prefer.
The declining importance of public markets for small and medium-sized businesses
The public markets are also focusing on larger more liquid companies. The number of publicly listed companies in the US has declined by 50% since 1996 while the average market cap has increased from $1.7bn to $8.3bn.
The Sarbanes-Oxley act has created high barriers to entry for small and medium-sized businesses. Prior to its introduction the median age of a company at the time of its IPO was 5 years vs 10 now.
The rise of passive investing and the increasing short-termism of public market participants has also resulted in a reassessment of the value of being public for many companies. Private equity companies can work more closely alongside management to devise - and execute on – strategy. They can provide equity and debt capital for growth. They can look through the noise of GAAP accounting. They can provide help with M&A. And they can take a short-term hit to earnings if it leads to longer-term growth.
Where as PE deal volume has grown by a 15% CAGR since 2009, public equity deal volume has declined by a 2% CAGR.
The decline of alpha in liquid fixed income products
Traditional solutions – or sources of lower-risk yield - no longer offer much alpha. Admittedly, the ability to generate alpha in liquid fixed income markets exists during periods of volatility such as that just experienced. But by in large the rise of liquidity providers such as index funds and ETFs has made alpha extremely hard to generate in the investment grade space.
That’s lead to the rotation out of liquid fixed income products to more illiquid private market products that generate excess spread.
The availability of alpha in less liquid private markets
I think the decade just gone was actually the first where the stock market outperformed the private equity industry. But over the long run private markets have generated much higher returns with less volatility. (Albeit as a former real estate guy, I don’t ‘buy’ the volatility bit – it’s just hidden from view.)
And the listed guys such as KKR, Blackstone and Apollo have all – historically - generated the highest and most consistent returns versus their smaller unlisted peers.
This continued strong performance with less volatility has resulted in more and more customers increasing their allocation to alternative products. I can’t tell you how many articles I have read in the last 18-months about the number of more liquid platforms wanting to pivot towards alternatives. Blackrock want to do it. Goldman want to do it. Charles Schwab want to do it. And countless other Japanese, European and other Asian fund houses want to do it.
I believe that we’re still in the mid-innings of a secular shift into private markets.
About twenty years ago, the allocation to alternatives was circa 8%. That’s now 25% which seems like a lot until you compare it to public equity (50%) and traditional fixed income (25%). Especially considering that the latter is no longer generating sufficient alpha to warrant its 25% weighting.
So, I can see the weighting towards alternatives increasing as investors re-assess the validity of a 60/40 portfolio in light of ultra-low rates and funding pressures.
Indeed, I have not seen a single LP study that shows a planned decline in allocation to alternatives.
Consolidation of GP relationships
New entrants face an enormous uphill battle because the top 10 managers have raised 68% of all private debt capital and 77% of all private equity capital in the last ten years. If you listen in to the earnings calls and speak to the LPs themselves, this is a trend that continues to exist and will very likely accelerate post Covid-19 as many small to medium-sized platforms struggle to raise. Apollo and Blackstone and KKR now have a franchise value that’s equivalent to some of the more vaunted names of yesteryear (such as Goldman).
Indeed, Apollo raised its latest Accord Credit fund ($1.75bn) in a matter of weeks.
The consolidation of GP / LP relationships is evident in the numbers. Apollo has increased the number of investors in its products by 60% since its investor day five years ago and has more than doubled the average number of products per top 25 LP from 5 to 12. AUM from managed accounts has also increased from $15bn to $26bn.
And there is a long way for consolidation to go; the market is still very fractured on both the GP and LP side and commitments to Apollo funds from its top 50 LPs represent only 0.25% of their portfolio. There is much further room for re-ups and cross-selling and for Apollo to become an all-weather solutions provider across the risk-reward spectrum.
In my opinion, the consolidation of relationships makes the barriers to entry even harder. The market will become increasingly bifurcated between the big guys at one end and the niche guys at the other. It will be extremely hard, if not impossible, for a small upstart to match the scale and resources of an Apollo, say. An oligopoly will emerge, and greater scale will result in the big guys being able to invest in the talent and in the technology to meet the increasing demand from customers.
Unlike the traditional product providers who are under massive fee pressure because of the rise of passive investing, fees and margins amongst the alts have been resilient over the last decade.
And I could be wrong but with customers desperate for yield and alpha, I see very little risk of future fee pressure. Especially when numerous private market funds are massively oversubscribed.
Huge addressable end markets
One of the common rebukes about the alts is that they’re already so big. Can they get bigger?
The answer is an unequivocal yes. The market is massive.
Globally, the addressable market in credit (bonds and loans) is circa 3x the size of the equity market. My notes say it’s about $200 trillion. And whilst the number of listed companies on the public markets dwindles, the size of the private equity market continues to grow unabated and is still only 1/3 the size of the listed equity market.
Structured credit, direct lending and investment grade private placement should all double in the next five years as the alts take more and more wallet share. The privatisation of credit markets – and equity markets for that matter – will continue. We’re still early to mid-innings and I don’t think it’s beyond the realms of imagination to foresee a buyout fund eclipsing $50bn in the next ten years as the alts target even larger companies.
The next ten years
So, as you think about the secular tailwinds that have propelled Apollo’s rise in the last decade and look towards the next decade, just ask yourself – have any of those tailwinds changed?
The answer is no. In fact, with ultra-low interest rates many of those same trends will very likely accelerate in the years to come.
Insurance as a strategic differentiator
Insurance has been the primary driver of growth in Apollo’s AUM and since that’s likely to be the case going forwards, I thought I would dedicate an entire section to it.
Apollo manages close to $180bn of insurance AUM vs $9bn in 2011 (a 20x). Most of this comes from its US and European spread businesses (Athene and Athora, respectively). But it also does P&C run-off (Catalina), variable annuities (Venerable), life and structured settlements and P&C insurance and reinsurance.
However, I am going to focus exclusively on the spread business as it’s the largest, the most important and bizarrely, the most controversial.
The business model
The business model is actually pretty simple.
Athene and Athora borrow money from policy holders and invest the proceeds into investment grade fixed income (95% of assets) and alternatives (5% of assets). The investment grade assets include CLOs, residential mortgage-backed securities, asset-backed securities, commercial mortgage-backed securities, commercial mortgage loans and corporate and government bonds. The difference in the rate at which they borrow (3%) and the rate in which they lend (4%), less operating expenses (0.25%) is their spread. As the shareholder equity is less than 10% of gross assets, the spread generated provides a mid-to-high teens return on equity.
The capital provided by policy holders and shareholders is long-term in nature. So, there is no risk of the ‘borrow short lend long’ dynamic that crippled many of the investment banks in the last financial crisis. Policy holders can’t suddenly withhold funding: they also ‘lend’ long to get their guaranteed return.
Furthermore, it might surprise you to know that Apollo’s main focus actually isn’t on the return side of the equation. Rather, they focus on the liabilities side - the cost of funds. They keep it as low as possible to ensure that they don’t need to be great investors to make satisfactory spread.
And shrewdly, they’ve understood that whilst the insurance business is a terrible place to take equity and credit risk, it’s a wonderful place to take liquidity risk because of the long-term locked-up nature of the liabilities. Provided you’re right about the solvency of the assets it doesn’t matter about mark-to-market losses. If the duration of the return matches the duration of the liability, you’re fine.
I will talk more about this in a second.
Apollo has been able to grow its insurance AUM 20x in the last 8 years because of a number of favourable industry tailwinds.
First, many insurers want out of the annuity business. It’s not a scale business for them and is significantly smaller than their P&C or mortality arms. Managing it provides them with no competitive advantage. So, what you’re seeing is a strategic rotation out of the annuity business.
You can see this in the news. Voya, Allianz, Generali, Lincoln and Manulife have all either shed assets or announced the planned sale of large blocks this year. This bodes very well for in-organic growth for Athene and Athora.
Second, many insurers have under-funded their blocks. Years ago – in search of growth and market share – they lured policy holders with attractive rates. That left them vulnerable should they need to generate high returns to make satisfactory spread. Previously, they could generate alpha by outsourcing the asset management to a traditional asset manager such as a Pimco or a Blackrock – guys who could earn excess return in the liquid fixed income market.
But the nature of the asset market has changed. And that’s the third tailwind. The secular decline in yields and the indexation and explosion of ETFs has eroded that alpha. Excess spread can no longer be generated in the liquid fixed income markets.
So, management teams face a stark choice; they can either re-build the AM arm in-house or align themselves with a manager that has private market expertise, or they can get out of the industry altogether by selling their block.
Increasingly, they’re choosing the latter.
And they’re choosing to do the latter because their shareholders are not willing to provide them with any more capital. Indeed, since its IPO in 2011, Apollo has raised more equity capital ($17bn) than the entire industry combined.
The embryonic relationship between Apollo and its spread businesses provides a number of competitive advantages for both.
For Apollo, they get access to two large permanent capital vehicles that generate a practically guaranteed recurring revenue stream. That’s hugely valuable when you’re looking to build a business as you can predict with a reasonable degree of certainty what your revenue line will look like 12 to 24 months out. They also get a client base that’s unique amongst the alts; one that actually just wants a 4-5% yield. That’s very attractive in any environment, but particularly in a rising market like the one we’ve experienced since the financial crisis. It puts less pressure on the opportunistic side.
For Athene and Athora, they benefit in a number of ways.
· They get a distressed debt expert helping them underwrite senior secured loans.
· They get a management team with a first-class franchise with many deep relationships with some of the biggest and most sophisticated investors globally.
· They get assistance when it comes to strategic M&A.
· They get a co-founder’s 100% focus and time (Marc Rowan, the architect of the strategy).
· They get a value-investors focus on downside protection / risk management.
· They get access to hundreds of dedicated insurance professionals.
· They get access to all the information that flows into Apollo’s platform. Just think for a second about how valuable that is. I happen to know one of the senior directors in Apollo’s European office. He’s wealthy enough to retire but when you ask him why he hasn’t, he always comments about the IP of working for such a large global platform. It’s one large information machine and that provides innumerable competitive advantages for an insurance business that is lending long and is exposed to secular shifts in industry dynamics and business models.
· They get access to a number of direct origination platforms that provide 200-300bps excess spread over more liquid alternatives. Triple net leases. Commercial mortgage loans. Financial services lending. Equipment and tools. Franchised finance. Aircraft leasing.
· And because they originate loans directly, they can insist on greater covenant protection, full due diligence and senior security in the capital structure.
Those competitive advantages are very hard for a traditional asset manager to replicate when the insurance mandate might only comprise 1% of its AUM and the entire insurance sector maybe only 10%.
You’re not going to get the same level of service. You’re not going to get the same level of attention. And you’re not going to get the same level of opportunity.
Athene and Athora are big clients of Apollo’s. And insurance is almost half of its AUM. They’re razor focused on execution.
Which leads me onto some of the misconceptions about the relationship. The reporting in the press is often one-sided, sensationalist and not grounded in fact.
Here are the points that I would like to stress:
1. Apollo owns 35% of Athene.
2. Apollo’s management team own 50% of Apollo.
3. The likelihood of Apollo’s senior management team putting junk on its own balance sheet – and in their own pockets - is extremely low.
4. This is particularly so when you think about the fees Apollo generates from its insurance platform and the growth potential ahead. You don’t kill the golden goose through poor risk management when shrewd risk management built the goose in the first place.
5. Only 5% of Athene’s allocation is to alternatives and neither Athene nor Athora are investors in Apollo Global’s private equity funds.
6. Athene has AA capital despite only having an A rating.
7. Not a single ‘shadow banking’ institution has gotten into trouble during Covid-19. Not one.
8. The fees are actually pretty competitive when you take into account the services and competitive advantage provided.
Growth will happen and it’s just a matter of when and how much. Athene provides Apollo with circa $16bn of organic flows a year. That’s a lot and circa 5% of total AUM. And as Athene and Athora scale, so will those organic flows.
Athene also holds surplus capital to support $80-90bn of additional assets and if you listen to the most recent earnings calls and read the recent investor presentations, both Apollo and Athene are very bullish about the in-organic pipeline. Particularly considering the tailwinds just discussed.
The Vivat acquisition by Athora is one that represents a “game-changer” according to the Senior Director of Apollo’s European office. It is similar in scale to the Aviva transaction that closed in 2013 and facilitated the growth of Athene. It’s also added circa $40bn of assets to Apollo’s AUM.
Athora has the potential to be a consolidator in the European annuities space much like Athene is in the United States.
And despite their size, Athene and Athora are still quite small. The market opportunity is substantial ($7 trillion for Athene alone). Furthermore, there is still much greater scope for Apollo to win even more wallet share from the insurance sector as between them the alts only manage 2% of total insurance assets despite being the market leaders in a sector (private markets) experiencing strong secular growth.
The biggest risk to growth, is growth itself. And that’s why you have seen – and will continued to see - a ‘buy and bed’ strategy. They will not buy blocks for the sake of growth if they can’t generate sufficient spread.
Barriers to entry
It has taken Apollo 12 years of 100% focus to get its insurance companies to the size that they are today. And whilst the combined size of Athene and Athora is about the size of Swiss Re, they’re still not relevant in the market yet.
Other alts are trying to manage insurance capital and I am sure that they will succeed in doing so. But they’re a long long way behind.
The insurance business is heavily regulated and very conservative. Think about all those relationships across multiple jurisdictions. It creates a massive barrier to entry, and I think Apollo’s golden goose is safe for the foreseeable future.
Business model benefits
It’s very hard to kill an alternative asset management business. And if they do die, they tend to die quite slowly and it’s usually self-inflicted. They’re not subject to periodic redemptions or daily withdrawals like a hedge fund or a traditional asset manager. They are not forced sellers so unrealised marks are just that, unrealised.
One of the reasons I am personally doing so well year-to-date is because of my knowledge of – and belief in – the recurring revenue stream. If you speak to the CFOs of Apollo, Blackstone and KKR they can all predict within a 95% degree of accuracy what their revenues will look like 12-months from now.
That’s extremely valuable in an uncertain world.
If you look at what happened in 2008 and 2009, all the alts actually increased their core FRE. The crisis was good for their businesses. The same thing has happened in 2020 – with Apollo expected to increase FRE again this year by 15%.
This stable income allows them to plant seeds. It allows them to hire talent. And it allows them to grow and build platforms and products in new business lines and geographies. Crucially, they can do all of that without the need to reinvest back into the business. They can continue to pay most of their free cash flow to shareholders whilst growing.
Finance is a scale business. And scale, begets scale.
This forum likes catalysts so here are a few;
· Recent C-Corp conversion.
· Likely inclusion in the Russell 1000 index at the end of June. (Think of all the passive and long-only money benchmarked to the Russell 1000 index.)
· Eventual inclusion into the S&P 500.
· Larger market cap so more and more funds can buy a meaningful amount of stock.
· Changes to 401k which allows savers to access private equity and credit products (it’s a huge untapped market - trillions).
· Impending realisations from Fund 8 (particularly the $10bn IPO of Rackspace Technology – many cloud-based companies have rocketed in value this year).
· The massive opportunity in dislocated credit which if you speak to GPs is their number one theme and focus. I have lost count of the number of GPs – big and small - looking to raise dislocated credit funds. Apollo is the number 1 player in the credit space and will very likely benefit enormously from the dislocation taking place.
· The planned raising of $20bn of high fee drawdown funds this year.
· Substantial in-organic growth opportunity for Athene considering the number of insurers looking to sell their blocks and the surplus capital available to support an additional $80-90bn of gross assets.
If you believe in the industry dynamics – that those dynamics are secular and have a long runway ahead of them – then the valuation of Apollo is not difficult to compute. Based on my research and knowledge of the industry, I am personally comfortable that those same trends exist today and will continue to exist for a very long time.
Post-tax FRE is expected to total $1.96 this year. I forecast that to continue compounding but at a lower rate, 15% a year. The lower rate largely reflects my view that margins (56%) have probably hit a ceiling. So, in year five, I anticipate post-tax FRE of $3.94 per share for a five-year forward p/e multiple of 13.19x for the management co.
I attribute a 25x multiple to that FRE because I think the runway – at that point in time – will still have at least five years to go. For those gasping at a 25x multiple five years from now, you’re welcome to throw me in front of the valuation tribunal if you wish – but it won’t change my view.
That gets me to a valuation of $98.56 per share for the management co in year five. Along the way I assume that 80% of post-tax FRE is paid out in dividends (so circa $14 per share in total).
On that basis alone, you get an 18% IRR.
The carry is interesting because it’s gone through periods of being valued, of being free and of being negatively valued. I went back and looked at Apollo’s share price since IPO and the implied value that was attributed to the carry by the market assuming a 25x multiple on then FRE. It ranged from 3.1x to more than 10x and averaged out at circa 5.6x.
Note: that was when Apollo was a listed partnership which basically ruled out half of a very valuable audience (long only mutual funds and passive investors).
Since its IPO, Apollo has paid out an average of $1.25 per share of net carry. As performance-fee driven AUM has doubled in that time period, so has the potential annualised net carry per share ($1.75-$2.25).
Putting a 6x multiple on $2 per share of net carry gets me to $12 today and $24 per share in five years’ time assuming fee-paying AUM doubles (which I think it will).
So, to summarise we have circa $52 per share of value in the management co and $12 per share of value in the carry business. That’s $64 today and a ‘look through’ p/e multiple of 13.13x ($52 / $1.96 + $2.00). And an intrinsic value of circa $122 per share five years from today.
Should that happen, your IRR increases to 26% which is excellent on a risk-adjusted basis considering the predictable nature of the core cash flow.
But Apollo also has a very valuable 35% stake in Athene which happens to also be compounding book value per share at 16% a year.
Value of Athene
Apollo is expected to earn normalised earnings of circa $0.90 per Apollo share from its pro-rata share of Athene.
That takes the true ‘look through’ p/e multiple today to 10.7x ($52 / $1.96 + $2.00 + $0.90). And the forward ‘look through’ p/e multiple in five years to a little over 5.3x assuming that Athene doubles its earnings which I think it will.
Assuming just 1x book, the value of Apollo’s Athene stake today is circa $14 per Apollo share. That increases the sum of parts valuation to $78 offering the brave investor a 50% discount to intrinsic value (plus a minimum 3% dividend yield compounding at 15% a year along the way).
If Athene’s book value per share continues to compound at its historic rate, that’s a further $28 of value per Apollo share in year five creating a five-year forward intrinsic value of $150 per share.
Should the market agree with me, that will generate a five-year IRR of 30% which I think is an incredible risk-adjusted return considering everything that I have outlined above.
Or to paraphrase Ray Dalio;
“A beautiful re-hedging.”
I hope my thesis is found to be compelling amongst members, I hope my analysis permits to be reactivated by the VIC council and I hope my eyes, brain and fingers allow me to get some well-deserved sleep.
Thank you for reading and I look forward to your comments, if any.
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