Thesis: COWN is worth $5.44 or ~100% above the current share price, based on a sum-of-the-parts (SOTP) valuation. The market severely undervalues the jewel asset of the company, Ramius, Cowen’s alternative investment management company with $8bn+ in AUM, which is worth $1.46/share alone. Additionally, Cowen’s underperforming Investment Bank division obscures the value of the entire company, and my base case SOTP assigns zero value to this business. The margin of safety is the value of the invested capital, worth $3.36/share. Potential impending catalysts include: changes in capital allocation by management (share buybacks) and continued fund flows into Ramius.

Note: Prices as of 11/2/2011.

I. Introduction

Cowen is a compelling opportunity for investors to acquire a portfolio of investment assets at a significant discount to tangible value along with a free option on the future of a well-regarded third party alternative asset management platform, Ramius. Sell-side coverage describes Cowen as a boutique investment bank with some ancillary investment holdings and asset management operations. In fact, Cowen’s value predominantly lies in its portfolio of investment assets and its asset management business. Cowen is worth considerably more than its current price even in a scenario where the investment bank is worth zero (or even has negative economic value).

The current incarnation of Cowen was formed in 2008 when the public investment bank Cowen merged with the alternative asset manager, Ramius. Ramius management led by Chairman/CEO Peter Cohen assumed control of the combined entity.  The merger left Ramius, mainly composed of Cohen and his management team, as the largest shareholders in Cowen with 28% of the company. Last year, Cohen and his top managers all earned total compensation of slightly below $1MM. Management is primarily incented by their Cowen equity and thus aligned with outside shareholders. Importantly, management compensation has not been excessive (certainly by Wall Street standards).  

In June of this year, Cowen acquired the mostly dormant remains of Labranche, the former NYSE specialist, in a transaction which bolstered Cowen’s cash position.   

II. Net Asset Value

Another way to value Cowen besides SOTP is based off of net asset value, which also serves as a sanity check. Cowen has a portfolio of mostly plain vanilla investments in regulated investment vehicles, which provides me comfort in their values. As such, Cowen should be viewed similarly to a closed-end fund given a large amount of value is in its invested capital. The NAV (or tangible book value) was $5.11 at 2Q11 so Cowen currently trades at 54% of NAV.

Note: Prices as of 11/2/2011.

Given the 14% decline in the market in 3Q11 and the effective closing of the capital markets, NAV clearly declined in the quarter. The sell-side pegs 3Q11 EPS (due out tomorrow) at a loss of $0.25/share, which translates into NAV declining 5%. This would bring NAV to $4.86 and put the company share price at 57% of NAV. As the table shows below, COWN can withstand a 45%+ decline in NAV and still trade at a discount.

Note: Prices as of 11/2/2011.

III. Invested Capital

The assets are liquid. The NAV is comprised of $110mm of cash and net liquid investment assets of $276mm. The invested capital of $434mm as of 2Q11, which translates into $3.74 per share, is moderately leveraged with $712mm of long market value and $278mm of leverage. Trading strategies are levered ~2.5x while merchant banking and private investments are unlevered. Trading strategies include macro, credit, event driven, and convertible arbitrage strategies and merchant banking includes PIPEs, private investments and healthcare royalties. Most of the funds are invested in Ramius products or alongside Ramius products in similar strategies.

In my SOTP analysis, I value the invested capital at 0.9x or $3.36/share, given the recent decline in market values and the comfort I have in the asset values. The company has shown the ability over more than a decade to compound prop capital at above market rates. Since inception, prop capital is up 651% versus the S&P 500, which is up 34% from 1999 to 1Q11. This effectively produced an ROE of 17.5% for prop capital versus a 2.4% return for the market.  Cowen’s strategies are thus reasonably attractive investment vehicles at par and compelling at a large unwarranted discount to NAV.

IV.  Ramius

Ramius is Cowen’s alternative investment manager and the company’s diamond in the rough (next to its investment portfolio!). Ramius has ~$8.5bn of assets under management as of 2Q11 for which the company has an economic interest. Surprisingly, Ramius is just about breakeven with a $65mm management fee run-rate now. Ramius has been unwinding its multi-strategy fund (<$500mm of AUM), which requires millions of dollars in expenses in auditing and accounting while new products have been ramping up, which partially explains the lack of profitability at Ramius. 

The fundraising side of Ramius has been strong over the past 3 quarters with new subscriptions of $2.2bn and AUM up 35% yoy as of 2Q11. In a tough operating environment in September, particularly for asset managers, Ramius launched its mutual fund Ramius Trading Strategies Managed Futures Fund, with $230mm in new AUM. The fund offers retail investors access to managed futures products with daily liquidity. Additionally, the company is winning mandates with a recent $400mm+ mandate from an Australia fund.

Cowen/Ramius recently spun off the activist fund, Starboard Value & Opportunity Fund, as potential investors were wary that an activist fund was associated with an investment bank. While Cowen had to give up some near-term income over the next quarter or two, the company expects this to ramp up to a $1bn+ fund sometime in 2012 (from ~$350-$400mm) for which Cowen is a significant minority shareholder. On the 2Q11 earnings call, management noted that the Florida SBA began funding its $125mm commitment to the fund. A differentiator for Ramius is its cash management product offerings (1/4 of AUM), which are low fee paying, but have had strong momentum in this low interest rate environment.

The market today irrationally ascribes no value to Ramius, an alternative asset manager with $8bn+ in assets. Cowen represents a great way to play the secular growth story in alternative asset managers, for a much cheaper price than peers.

Alternative asset managers (APO, BX, FIG, KKR, OZM) trade at multiples of net income (“economic net income”), dividends (distributable earnings”), and normalized earnings so a direct comparison is not possible. Based off a traditional asset manager valuation, a multiple of AUM, I believe Ramius is worth $1.46 on 2% of fee-paying AUM. I believe this is conservative given the mix of assets, this is closer to where traditional asset managers trade (~1.5% EV/AUM), and there is the optionality in the performance fees that accrue in the hedge fund and private equity products over time. Note: alternative asset managers trade at ~7% EV/AUM, although this is not the proper way to value alternatives asset managers given the complex fee structure.

V.  Cowen and Company (Investment Bank)

Cowen’s investment bank is the company’s pig. I don’t think management realized how dire the infrastructure of Cowen was when it consummated the merger. Management has realized these deficiencies and has been investing in people and technology.

Breakeven in the investment bank is now down to $75mm in revenue as the company has made variable expenses a larger proportion of the expense base. Clearly the capital markets are currently shut, particularly for the deals that firms of Cowen’s stature advises. However, the abysmal performance of the investment bank over the past few year masks the structural improvements. 3Q11 results at the investment bank should represent a bottom point given the near total shutdown of capital markets as a result of the Eurozone crisis. 

Interestingly, 50% of the senior revenue producers have been there for 12 months or less and given that it takes ~6 months to produce revenues, there is upside if the capital markets ever open up. If the investment banking environment continues to be weak, I am confident that Peter Cohen and team will do what it takes to right size the business.

Fortunately for a successful investment in Cowen’s stock, the investment bank can continue to be a dud and a cash drain. My biggest fear is that the investment bank is worth a large negative NPV. To stress this, I assign $160mm of tangible common equity to the investment bank, even though the investment bank only needs $70mm or so of capital to run. In my base case, I assume that the investment bank is worth a negative $160mm or the capital outside the company’s invested capital is worth nothing. 

As another sanity check, other mid-market focused investment banks trade at 0.7x TBV or below the theoretical liquidation value versus 0.54x for COWN. Some of these boutique investment banks trade at higher price to tangible book multiples than Cowen and lack the growing alternative asset manager.

Note: Prices as of 11/2/2011.

VI. Deferred tax valuation allowance

Cowen has ~$240mm in a deferred net operating loss with a 100% valuation allowance, which translates into $2.06/share. The company doesn’t expect to use all of it, but clearly this has value. In my base case, I value the NOL at 30% of the valuation allowance or $72mm for $0.62/share.

VII. Cowen has a conservative financial position and operating model.

Cowen operates with a very low level of leverage for a financial institution.  At 2Q11, equity to assets stood at 36%.  Cowen has no debt beyond repurchase agreements.  Against this $170mm in repurchase funding, Cowen has $110mm in unencumbered cash.  Cowen is certainly no MF, levered over its head and excessively vulnerable to capital market dislocations.

Cowen also runs a very vanilla investment banking operation centered on cash equities.  Cowen has no structured finance, exotic derivatives, or mortgage desks with opaque exposures.  It has no major debt trading desks requiring inventory finance. 

Cowen’s investment bank may or may not succeed in overcoming the current weak banking environment to earn an attractive return on equity in the short-medium term, but it is certainly not exposed to the types of solvency or liquidity worries that have troubled investors in the investment banking sector over the past five years.  While Cowen’s valuation temporarily suffers by association from its classification as an investment bank, this is no Lehman or MF in the making. 

VIII. Valuation

Putting it all together, I believe Cowen is worth $5.44, which represents ~100% upside from the current share price in the base case.

Note: Prices as of 11/2/2011.

IX. Risks to Thesis

• Major underperformance or capital loss on invested capital and/or third party managed assets
• Extended closure of capital markets activity weighs on investment banking results

• Capital Management: As of 2Q11, Cowen had $110mm in cash and $277mm in net liquid investment assets along with no non-repo debt on its balance sheet.  Cowen has significant resources to buyback stock – a highly accretive proposition for a company trading around 50% of book value.  Cowen does have a $20mm stock buyback program launched in July of this year.  A more significant buyback program once the current $20mm is exhausted or a tender offer would be welcome catalysts.  Although the company has previously expressed a preference for using its excess cash to seed new asset management products, with Cowen down 43% YTD and now trading at such a massive discount to net asset value, this math may have changed.
• Investment bank restructuring: Cowen management may be running out of patience with the earnings drag caused by the investment bank in this environment.  The investment bank could be a potential source of additional franchise value in a more normalized capital market environment.  Fortunately for shareholders and unfortunately for bankers, vanilla investment banking operations can be rapidly restructured or shutdown.  There are no difficult to reposition industrial machines or unionized workforces.  As major shareholders, if it becomes apparent that the investment bank will not generate adequate profitability in a reasonable timeframe, management is incentivized and capable of dramatically and rapidly scaling back operations.  Cowen might also look to sell the investment bank which could have material franchise value.
• Reopening of capital markets: Our base thesis is extremely pessimistic on the outlook for capital markets activity in the relevant future.  Significant upside exists should current capital market volatility ease and deal activity resume, Cowen’s investment bank would shift from an expense center to a profit generator.  At the very least, diminished investor negativity towards the investment banks should result in a re-rating of Cowen.