Apollo Is Not A Lyre

Apollo Global Management, LLC (APO-$16) is a high risk, potentially high return situation.

Conventional wisdom is that finance companies benefit from rising rates. I don’t think this is true at APO since AUM (assets under management) will be vulnerable to negative credit events. More, I do not think the Company will be able to sustain its current shareholder payout which aggregates to $190 million per year, compared to a current income of $134 million and a cash flow of perhaps $200 million (adding back depreciation).

The APO security, which is complex in management and profit participation, has experienced dramatic reduction of distribution per share, from $3.98 in 2013 to $2.89 in 2014 to $1.38 in 2015, with a going forward rate of $1.12, now yielding a frack over 7%.

Financial companies are first distinguished by the relative proportions of their investment, fee, and transaction income. Commercial banks depend primarily on the investment income of conventional “spread banking”, further differentiated by a mix of commercial, consumer and real estate lending portfolios. More recently, banks engage in originations that generate transaction fees and sometimes trading losses.

Investment banks, on the other hand rely on transaction earnings, which are commissions and trading profits, in addition to fees on corporate services such as financings, mergers and project finance.

Apollo and the other private equity players are different again in that they earn investment and fee income. In this manner, APO earns management fees on capital raised from institutions, while also participating in the earnings generated by the capital. The Company is also able to generate transaction income, although this category is more likely to be a net expense.

The Company has built a strong fund collection effort by private labeling high return funds, largely backed by portfolios of middle market corporate loans and retail annuities. I think it is fundamentally disconnected to think such a portfolio will generate sufficient funds to sustain the current payout. And that return is reduced by multiple fees assessed through APO’s intensely convoluted structure.

APO is led by the right team; Leon Black, Joshua Harris and Mark Rowan were leaders in the Drexel Burnham junk bond operation that helped define the Eighties.. Management owns little APO stock. Black, the CEO is the oldest at 64. Does history repeat?

The stock is owned by retail investors. Institutional ownership is below average and that which exists is largely brokerage firms with whom the Company is likely to conduct related-party transactions.

The Company self-identifies as an innovative risk-taker. It maintains an active investor relations effort. Analyst coverage is wide and generally favorable. I think this is based on the expectation that a changed accounting principal (de-consolidating the invested funds) will result in a robust earning pattern. It doesn’t affect cash flow. I do wonder how the de-consolidation affects whatever fiduciary relationships the Company has towards its fund clients and shareholders.

What will happen when interest rates go up?

First, better investment returns will be available elsewhere and fund raising will stall. Second, we will learn the strengths and weaknesses of the sub-prime corporate market. Conceivably, APO will benefit from a higher level of activity to earn greater fees and make astute placements. More likely, APO portfolios will incur the costs of distress investing, including haircuts, hardball and litigation. And APO liquidity, like the high-yield market, is untested.

BizProf100