|Shares Out. (in M):||248||P/E||16.5||20.1|
|Market Cap (in $M):||9,188||P/FCF||17||21|
|Net Debt (in $M):||-206||EBIT||504||531|
|TEV (in $M):||10,372||TEV/EBIT||20.6||19.5|
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Ares Management Corp. is an alternative asset manager with $149 Bn of assets under management and a strategic focus on credit investment strategies (74% of AUM). The stock trades today at 12x – 13x fee-related income (“FRE”), too cheap for a business that has and will continue to grow earnings in the mid-teens. Like the other alternative asset managers, Ares has a complicated balance sheet and messy income statement that make the stock screen poorly, but when one peels back the layers, it becomes clear the business is minimally levered with a simple model: earnings are a function of assets under management x an annual management fee with 60% incremental margins. For a variety of reasons laid out below, Ares’s AUM is poised to grow at a 20% CAGR over the next several years, leading to FRE growth of 25-30%. Applying a market multiple of 15x (too low in our opinion), results in a $41 stock and a $45 total return with dividends with a long tail of continued growth. At a more appropriate 20x FRE, the total return is closer to $57 (+60%) over the same period.
The company has drawn increased investor attention since converting to a C-corp and changing its dividend policy to a fee-related earnings payout in 2018, but the stock still trades at a discount to the market at 12x-13x forward FRE ($2.46 of proforma FRE on a ~$31 price adjusted for ~$4 of balance sheet assets). With potential for accelerating earnings growth over the next few years and a 4.6% dividend yield, Ares warrants an above average multiple and a continued rerating could drive returns meaningfully higher. Ares is growing faster than its peers (20%-30% FRE growth vs. teens growth among peers) and is likely to outperform over a multi-year period.
High level, the Ares thesis and earnings drivers are straightforward. Management fees grow linearly with AUM and generate 60% incremental margins; investors tend to fixate on the near-term trends and fail to consider the long-term AUM potential of Ares’ various strategic initiatives.
Current fee-related earnings = $1.25 FRE on $97 Bn of fee-paying AUM and ~$1 Bn of management fees
(+) $30 Bn of AUM being raised (ACOV VI, ACE Europe, ARCC), $300m management fees
(+) $26 Bn of AUM raised, but not yet earnings fees, $260m management fees
(+) $30m of incremental fees from ARCC in 2020 (waived prior to Q4’19)
= $56 Bn of additional fee-paying AUM, ~$600m of additional fees and ~$1.20 of fee-related earnings at a 60% incremental margin (Ares’ effective tax rate is in the 8%-13% range due to non-cash expenses and tax assets).
Additional growth from Ares’ potentially deci-billion AUM growth opportunities in SSG, the Sumitomo partnership and Aspida will drive additional upside over the next few years.
Attractive Industry Dynamics
The alternative asset management industry has undergone a structural shift that has led to a higher concentration of assets under management (“AUM”) among a few large players. Ares is positioned to realize an outsized benefit from this trend as the smallest of the public $100bn+ multi-strategy asset managers. Over the last five years, AUM among the top publicly-trading alternative asset managers (“alts”) has grown at an annualized 12% rate, nearly doubling assets to $1.5 trillion. The surge in demand for alternative investment strategies this cycle has been driven by investor demand for scarce “yield” investments, growth of private credit as banks exited many lending markets and relative outperformance of private investment strategies over public investment strategies. These trends show no sign of abating and will continue to strengthen competitive advantages of the larger alts.
The growing concentration of assets among a small group of managers creates a virtuous cycle of scale benefits that allow these firms to hire top talent, employ greater research and marketing resources and offer bespoke strategic, tax planning and reporting services. Large asset allocators, whose investments are the lifeblood of the industry, prefer making large investment allocations to a handful of funds with sophisticated tax, compliance and audit capabilities. As the alts’ gain scale, resources and capabilities grow and their margin expand, further deepening their resource advantages over smaller peers.
Private markets are growing faster than public markets, presenting a larger opportunity set for alternative asset managers
Private Markets Strategies Have Outperformed Public Markets
Source: Apollo IR
AUM has grown at a mid-teens CAGR among the large public alternative asset managers
Ares has a high concentration of fee-related earnings
The market perception of the alternative managers has improved in recent years as the public players have converted from partnerships, requiring K-1 tax filings and prohibiting index inclusion, to C-corps with slightly improved governance. The stocks have partially rerated, but still trade below market multiples and well below levels of companies with similar growth and/or capital return characteristics. Ares has reinforced its earnings stability by pegging its dividend payout to fee-related earnings, and eliminating volatility associated with payouts tied to lumpy performance fees. Ares is uniquely able to tie the payout to fee-related earnings because 70% of Ares’ earnings are generated by management fees whereas its peers generate ~55% of earnings from fees. In a market that rewards earnings stability and visibility, Ares has an advantage. Fee pressure has been a concern for other public asset managers, but fee rates have been resilient among the alternative asset managers. Even performance fees, while lumpy, have generated consistent earnings over the last ten years. The growing appeal of Ares’ consistent earnings, dividend and growth should help the stock outperform.
Long-term, Ares has an opportunity to compound shareholder value by retaining performance fee income to seed investments in new funds. With dividends funded by fee-related earnings, Ares can retain incentive-related earnings on the balance sheet and use the capital to seed 10%-15% anchor investments in future funds. Through this retention and seeding cycle, $250m or ~$1 p.s. of retained incentive fee income could seed a $1.7 Bn fund generating $15m in management fees (calculated excluding Ares’ AUM in the fund) and ~$20m in annual incentive fees (assuming 8% returns) while growing Ares’ initial $250m investment. After five years, the initial $250m investment and related fund earnings could drive over $500m of value and generate a 13%+ IRR for shareholders. Incentive fees generated by the new fund can be used to seed other funds and incentive-driven earnings compound on Ares’ balance sheet. This dynamic is only beginning to play out under the company’s new dividend policy and is an underappreciated source of long-term value.
Attractive growth outlook
Ares is in the middle of a fund-raising cycle for two flagship funds and a handful of small strategies that could drive an incremental $30 Bn of AUM over the next 12-18 months. The company also has a substantial amount of “shadow” AUM which represent committed or raised capital that is ready to deploy (this dry powder was $26 Bn as of year-end). Securing such a large sum of capital through fund-raising is challenging, but there are few reasons why Ares is likely to succeed.
First, Ares has a successful track record growing each iteration of its flagship funds. The slide below from Ares’ September 2019 investor presentation clearly shows the step-up in AUM of each fund vintage. The ACOF V private equity fund raised in 2015 was over 2x larger than ACOF III raised in 2008 and ACOF VI, currently in the market, will be larger than ACOF V (ACOF VI is estimated to be a $9.5-$12 Bn fund). A similar trend is apparent in the Ares Capital Europe (“ACE”) funds and across many of Ares’ strategies (ACE V will likely be a $10 Bn fund). However, none of this would be possible without strong investment returns and Ares has proven capable of generating industry-leading returns across strategies and fund vintages. The firm had some missteps with an energy private equity fund over the last few years and its real estate segment remains subscale, but overall fund returns are competitive with returns of its larger peers. Ares has also made a few new hires on the real estate team that are driving improving results.
Ares is also raising second iterations of a few smaller strategies including: (1) US Senior Direct Lending II, (2) Flagship Alternative Credit, (3) Liquid Credit, (4) Special & Energy Opportunities, (5) Real Estate Opportunistic Fund II, (6) European Real Estate Value-Add II and (7) Real Estate Debt. Many of these funds will be smaller, $500m-$2.5 Bn funds, but collectively they could add over $10 Bn of AUM.
Finally, Ares is likely to raise additional capital at Ares Capital (ticker: ARCC), the public BDC it manages. Under new regulations passed last year, BDCs are allowed to increase leverage and with Ares Capital Corp at ~0.9x debt/equity today, the company could increase assets $8.9 Bn before hitting asset coverage and debt/equity limits closer to 2:1. Historically, Ares has conservatively managed ARCC, opting to keep leverage low and prioritize healthy dividend coverage so ARCC is unlikely to maximize leverage, but the company will move gradually towards 1.5x debt/equity, adding $4 Bn to Ares’ AUM. While there has been much consternation about the quality of ARCC’s investment portfolio in the current environment, and while I expect write-downs in the portfolio, the firm has an excellent track record across market cycles. Non-accruals are generally below 1% (while some peers have 5%+ non-accruals) and have never been higher than 3% of the portfolio going back to 2007. The portfolio is under-levered relative to peers and has generated net gains on defaulted loans over the life of the fund. Over the last 12 years, ARCC has only had net realized losses in 2009 and the value lost was small: $46m or 2.3% of the investment portfolio at the time. On a relative and absolute basis, ARCC will likely emerge from the current economic crisis with manageable permanent losses and having deployed a substantial amount of capital in attractively priced opportunities.
Beyond visible fund-raising opportunities, Ares has a few large, open-ended growth drivers: Aspida, SSG and Sumitomo. The first opportunity is through a recently acquired insurance and annuity subsidiary, Aspida. Blackstone and Apollo operate similar entities, FGL Holdings and Athene, respectively, that have been large sources of AUM growth over the last few years. Ares has only recently launched its version of the strategy and, with the passage of the SECURE Act last year that allows annuities to be sold in 401K plans, should be well positioned to capitalize on future opportunities. Ares’ credit expertise is particularly useful for managing large pension portfolios that are increasingly being sold to third-party entities. The other large, open-ended growth opportunities are driven by new strategies and partnerships in Asia.
Earlier this year, Ares acquired SSG Funds, a leading Asian credit manager, and announced a partnership with Sumitomo Mitsui, one of Japan’s largest banks. SSG brings over $6 Bn of AUM and provides Ares with a talented team (that took a lot of Ares stock in the deal) with superior “on-the-ground” knowledge and experience that will serve as the lynchpin to Ares’ growth in China and Southeast Asia. In Japan, Ares will begin distributing its credit products to Sumitomo’s retail and high-net-worth clients through a distribution partnership. The company has not put any estimates around the asset growth potential of the Sumitomo partnership, but demand for yield products is high in Japan and Sumitomo’s retail deposit base is large so it could represent a multi-billion AUM opportunity for Ares. Sumitomo showed support for the deal by acquiring a 5% stake in Ares. Collectively, Aspida, SSG and Sumitomo have potential to attract tens of billions of additional AUM for Ares.
Underappreciated margin expansion opportunity
Over the last three years, Ares has grown management fees at a 15% annualized rate while fee-related earnings grew at a 20% CAGR. Ares’ profit margins on management fees have expanded from 25% to 31% (+600 bps) since 2016 and will continue to widen as AUM and fees grow. The continued potential for margin expansion will drive much higher earnings growth at Ares relative to its peers.
Ares operates with FRE margins in the low-30s while its peers generate FRE margins above 50%. A portion of the margin gap is structural and will not close because Ares does not charge monitoring and transaction fees, but at least half of the gap—10% margin expansion—is attributable to scale and should narrow with AUM growth. Incremental margins on management approach 60% so Ares’ earnings should continue to grow faster than the topline.
Ares’ investment focus is another potential advantage because credit strategies are more scalable, requiring fewer employees to manage incremental capital, and are a much larger global market. Generally, every private equity deal requires a different board or management team and stable of service providers. Closing and managing deals requires more resources and executive talent with limited capacity so putting incremental capital to work requires a greater investment in talent and services. With credit, large increments of capital can be deployed by the same investment committee (perhaps with a few extra analysts and sector specialists added at large increments of capital).
At 15x forward FRE of $2.46, a conservative multiple given Ares’ growth trajectory, Ares is worth ~$41 including ~$3.70 of balance sheet assets. Layering in potential growth from Aspida, the Sumitomo JV and SSG could drive FRE above $3.20 over the next few years: worth $52 at 15x. In addition to FRE-driven sources of value, Ares will likely generate over $1.50 of incentive fees over the next two years while paying $3.20 in dividends, adding ~$5, for a total return of $45-$57 (+30%-60%) at 15x.
A 15x multiple may be conservative given Ares’ earnings consistency and growth profile. As a credit-manager with expertise in distressed credit investing, Ares’ earnings have been countercyclical historically, growing out of recessions and volatile market environments. A stable, countercyclical, earnings stream growing 20%-30% is difficult to find, and similarly high growth companies trade at significantly higher multiples. Applying a 20x FRE multiple to the FRE figures above drives the total return potential above $70 (+100%).
The other alternative asset managers offer attractive returns as well. KKR is particularly cheap when viewed on a multiple after backing out the substantial value of investments on the balance sheet. However, some investors view the balance sheet risk unfavorably and see it as complicating exposure to the favorable industry tailwinds behind the alternative asset management industry. Ares also has a higher and more stable earnings growth profile given its size and focus on credit strategies. Ares’ unique combination of stable, high growth earnings, large open-ended growth opportunities and low exposure to volatile performance fees is unique among its peers.
Upside from the compounding value of retained performance fees will further improve long-term returns.
Market Risk: Some of the underlying investments in Ares’ funds may be permanently impaired in the current environment, lowering the total FPAUM base. Ares’ concentration in credit strategies is an advantage given the outperformance of credit relative to equities year-to-date, but poor market performance will slow growth slightly in Q1. Offsetting this negative AUM impact is Ares’ proven strength investing during times of distress. The firm has generated superior returns exiting crises and will likely have deployed a substantial amount of capital year-to-date. In addition to the direct impact of market volatility on AUM, the environment has likely pushed back some of Ares’ fund-raising efforts a quarter or two.
Performance: This is a performance driven industry and failure to maintain Ares’ strong track record could impair AUM growth. Ares latest energy fund had poor returns (as did many of its peers energy funds) and the firm has a few investments that draw substantially more negative media attention than their impact on Ares AUM would suggest (see: Neiman Marcus, all of retail is <2.5% of firm AUM and Neiman was largely written down in the past). I expect there to be defaults and bankruptcies among Ares' underlying investments (as there will be for all of the alts), but I aggregate losses will be modest and will be crowded out by the benefit of increased capital deployment at distressed prices.
Regulatory: Democratic politicians favor increased taxation on private equity funds/returns and limitations on leverage and monitoring fees. Joe Biden has not been as outspoken as other Democratic candidates on the topic, but, if elected, he is likely to implement marginally unfavorable regulatory reforms. Ares is less exposed than its peers given its lower mix of incentive income and lack of monitoring fees.
Control: Common shares constitute 53% of total shares outstanding with the other 47% held by employees and insiders (operating group units). The operating group units have a super voting right that effectively gives Ares employees control and means common shareholders are at the whim of management and its strategic direction. Michael Aroughetti is an astute capital allocator who created value at ARCC as the engineer of the American Capital acquisition and has astutely led Ares into potentially transformative growth avenues (Aspida and the Sumitomo partnership) so investors should be well served by current leadership. Employees having skin in the game also better aligns their interests with shareholders’ interests.
5-Year AUM and Management Fee Growth CAGR – Ares’ Margin Opportunity is Underappreciated
Ares has grown AUM in line with peers…
…and has generated above average management fee growth.
Ares has a much greater margin expansion runway as it continues to scale…
…with a higher mix of management fees (as opposed to more volatile performance and monitoring fees)
Retained Performance Fee Value - Potential Long-term Source of Value (not included in valuation)
Fee-paying AUM growth from fund-raising for flagship funds
Additional color on SSG and the Sumitomo partnership
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