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Continued from here. And plse ref. my (alternative) asset manager table here. Taking a look, I marvel again how conservative most managers are in terms of net cash/investments. Less than 1 in 10 has net debt, while the average manager’s on a 4.6 Price/Cash multiple – 22% of the average market cap. consists of net cash/investments! This has always puzzled me. In general, particularly now, I don’t believe shareholders are being properly rewarded for this asset/financial strength. You’d think managers would be a little savvier about shareholder value..?! And reasons for this surplus cash? I can think of three:

i) Management Nap Policy:  Ah diddums, management finds it hard to sleep, or even nap, unless they’ve a large chunk of cash lying ’round so they feel warm & cozy… Maybe they’re even hoping a lap dancer will be impressed at the size of their…balance sheet? A touch sarcastic? Don’t forget a company’s really just a collection of people – which can sometimes be wonderful…or terrible! [btw Here’s another collection of people]

ii) Financial Backstop:  OK, let’s try again! We’ve noted managers are a geared play on the market, and falls in AUM can lead to a vicious AUM/P&L loss spiral. So, a substantial cash backstop’s just sound financial management? Er, no! First, look at some of these pigs – their cash is a multiple of their total annual expenses! We’re also talking about a high margin business model, with a large component of employee comp. being discretionary/bonus driven. This offers plenty of cushion to absorb potential shocks. And if AUM falls to a new (lower) base level, like any business you need to adjust your cost base accordingly!

But I hear the objection – that will impair our ability to capitalize on a rebound in the market/AUM! Sigh, if every business thought like that, where would we be? OK OK, let’s think about delaying employee/expense cuts for a year or two while everybody waits for the great rebound. How? Just pay out all your cash to shareholders…and I’ll tell you! Seriously, any sensible CFO will always lock down an airtight back-up credit facility. The small fee paid for this safety net, and the distribution of all available cash, offers a far better shareholder return. And it has an added benefit: As AUM dwindle, and they draw on a facility to fund bloated expenses, hopefully it sharpens management focus vs. allowing them to wallow in idle cash. This, of course, is true for many other businesses/models out there…

iii) Seeding Funds:  Needing cash to seed funds is a vastly over-estimated concept. In fact, it seems to be simply the justification for i) above! I’ve dealt with this myself; There are only 3 things that really matter: Fund performance, size & life. Some investors insist on good performance (heavens..!?), don’t want to be more than (say) 5-10% of the fund, and/or won’t invest until the fund has (say) a 1-3 year track record.

Apart from literally starting the fund, seeding does nothing for you in meeting these criteria. Yes, even in terms of size – say you’ve a spare $50 mio. Well, that likely implies you already manage billions, and want your new fund to be another billion dollar success. So $50 mio of seeding might just persuade an investor to commit an extra $2.5 miooh yeah, that’ll get you there!? And I hardly need point out seeding does nothing for performance or fund life…

All this smacks of management just taking the easier path, to the detriment of shareholders. Building a fund’s not about seeding, it’s about the hard grind of sales & marketing, and building up (real) relationships/favours with clients. That’s what your shareholders paid for! You can offer prospective investors fee rebates for new fund support, initial fund fee waivers, or perhaps a low fee founders class. You can possibly offer them access to closed or restricted funds in return for new fund support etc. etc. [All done in an appropriate manner, of course].

Actually, here’s a revised manager table, with a new Cash & Investments / Market Cap. column, for reference:

Manager Ticker Price Net Cash & Inv (m) Net % of AUM Net Cash & Inv/Mkt Cap
MPC Capital MPC:GR 1.16 (65) N/A (189)%
Affiliated Mgrs AMG:US 100.76 (1,196) 3.8% (23)%
HCI Capital HXCI:GR 0.58 (3) N/A (14)%
CIFC DFR:US 6.07 (14) 1.0% (12)%
Lazard LAZ:US 22.93 125 1.7% 4%
Oaktree OAK:US 36.41 288 7.5% 5%
Partners Group PGHN:SW 159.0 315 13.2% 7%
Carlyle CG:US 21.15 889 4.8% 14%
Apollo Global APO:US 10.91 713 5.5% 18%
Ashmore ASHM:LN 3.28 426 4.6% 18%
Och-Ziff OZM:US 7.21 565 8.1% 19%
Sprott Inc. SII:CN 4.78 160 6.8% 20%
Polar Capital POLR:LN 2.00 42 3.6% 26%
KKR KKR:US 11.52 2,642 11.3% 33%
GAM Holding GAM:SW 10.35 772 1.1% 38%
Blackstone BX:US 11.72 5,686 4.7% 43%
Record plc REC:LN 0.17 20 N/A 53%
Integrated Asst Mgt IAM:CN 0.65 11 0.5% 60%
Charlemagne CCAP:LN 0.10 18 1.0% 62%
Gottex Fund Mgt GFMN:SW 2.54 48 0.5% 62%
Sparx 8739:JP 5,060 6,800 0.9% 65%
Man Group EMG:LN 0.76 978 1.1% 70%
Fortress FIG:US 2.93 1,087 0.9% 71%
Capman CPMBV:FH 0.90 60 0.5% 79%
Argo Group ARGO:LN 0.14 16 (2.8)% 157%
Cowen COWN:US 2.38 578 (3.0)% 213%
Altira A7A:GR 2.59 30 (1.9)% 252%
IFMI IFMI:US 1.02 69 (0.7)% 529

OK, let’s move on. I’ve added 3 of the 4 other ‘managers’ (who don’t disclose or have a comparable % of AUM) I mentioned here. Let’s cover these first:

MPC Capital – shipping focus (as with HCI) might be interesting eventually…if they survive..! Equity of EUR 4 mio now supports a 205 mio balance sheet. HCI Capital‘s loss making, but has a better EUR 42 mio of equity vs. a 98 mio balance sheet. Record plc‘s the best of the bunch, and cheap as chips – this could possibly turn out to be a double or triple. Of course, it looked cheap all the way down… Despite recent struggles, it has an extraordinary 38% operating profit margin (and GBP 20 mo of cash), providing wonderful support for the current share price.

My problem’s their carry trade/forward rate bias strategy. This is incredibly correlated with risk sentiment/volatility (hence, the struggle for the past few years). So, with any bout of market volatility (like now), I can look forward to Record’s multiple (as a manager) getting hammered, and their performance and (underlying implied) AUM suffering too. OK, I’m being a little unfair, you run much the same risk with other managers, but buying Record’s asking for trouble… Allow me the delusion of buying, say, an emerging markets manager and and I can hope their fund performance/AUM will outperform developed markets managers, for reasons I’ve previously outlined. I’ll keep watching though – there may be a right time/price for my portfolio – I expect it’ll eventually get taken out in an MBO.

I’ve discarded 3i Group – as I suspected, it’s external fund management/fees simply mitigate a bloated expense structure, so it’s best to consider it separately as a PE fund at an attractive 38% discount (though, there’s plenty of similar London listed bargains available).

Taking the rest of the table, I’m ignoring all managers trading higher than an ex-cash 5% of AUM. Regardless of revenues/profitability, they’re obviously trading at levels (some which look crazy!) that offer limited upside, or make me distinctly uncomfortable. If I can’t find anything otherwise compelling, I can always return to these managers for a closer look. For the rest of the bunch, I’ve dug deeper, primarily focusing on fees as a % of AUM, management fee revenues, performance/incentive fee revenues and operating profit margins, plus  key ex-cash ratios. Excluding 2 disasters, I’m happy to observe an average 24% operating margin, nicely confirming my previous 25% margin estimate. With over two-thirds of these positive operating margins at 20%+, this is clearly a steady/high margin industry.

I don’t think Net Income & P/E ratios are that enlightening when it comes to analyzing/selecting managers. Fee rates are an interesting sideshow also – you can analyze via actual revenues anyway. With performance fees subdued these days, I don’t feel the need to adjust downwards for them. In fact, I’d suggest you survey the history & breakdown of revenues. In some cases, you’ll see how large performance payoffs can actually be, and the free (‘option‘) upside that’s inherent in some valuations right now. And remember, as I said in my last article:

‘For asset managers, % of AUM helps you find the right neighbourhood, while Price/Sales helps you find the right house. Both are equally important…And as everybody who knows their property tells us (or used to!), a bad house in a good neighbourhood’s often the v best investment in the long term..!’

While I continue my drill down, I wanted to highlight (good & bad) shares that particularly jumped out at me so far. [Obviously, many managers are reasonably valued, but overall the sector’s under a cloud – I found few over-valued shares]. The worst valuation I saw was Affiliated Managers: This is an acquisition fueled (and over-valued) growth story, like too many US companies. Maybe I’m a little unfair, there are plenty of cheap US traditional managers available who stick to their knitting. Janus (JNS:US) & Artio Global (ART:US) are both cheap (despite my reservations about traditional managers). I’m bemused AMG trades for double my estimate of fair value – while, coincidentally, they only appear to hold about a 50% ownership stake in their AUM. Did investors not notice this, or the v significant non-controlling/minority interests on the P&L and balance sheet..?!

CIFC, a CLO manager, looks similarly overvalued. Fees are at 0.31% of AUM, within the usual 0.20-0.35% range you see for CLO, CDO & traditional bond managers. So CDO/CLO managers are not so alternative! Noting the lower fees, and the rarity of pure bond manager M&A transactions, it’s probably better to focus on a revenue & margins valuation with bond managers.

On the other hand, IFMI‘s valuation is absolutely fascinating. I can visualize scenarios where the current share price, which trades at a 75-80% discount to Book/Cash, could multiply 4-8 times over! Against that, you’ve got to weigh up further possible declines in their CDO AUM, and the leverage & market/volatility exposure of a 70% owned broker-dealer. Oh, and losses (but there’s still a fair equity/cash cushion to absorb these) – these appear to originate primarily from the broker-dealer. This is a v difficult business to analyze in sufficient detail, and on which to make any kind of informed call…

I’m pleased to see Ashmore trading a little below fair value, while Charlemagne‘s got about 75% upside currently. This confirms Argo Group (ARGO:LN), which I own, remains the cheapest (alternative) emerging markets manager available. Of course Argo’s a micro-cap, so I’d prefer to avoid another small-cap manager in my portfolio. This eliminates Altira & Integrated Asset Management for the moment, even though they’ve a v different AUM focus. Pity, they offer potentially significant upside – something to remember. IAM’s static AUM over the past couple of years has pushed back profits, and the share price – if you’ve a free slot in your portfolio, this could possibly be (more than) a triple longer term. They’ve flagged up a poor P&L near-term as they pursue AUM growth, which might prompt a lower share price entry point to come.

Polar Capital appears pretty fairly valued, but I note two interesting facts. They tend not to boast about being an alternative asset manager, but their fees are decidedly alternative (despite their funds being mostly long only)! Their fee rate comes out at 1.25% (most long/traditional managers manage 1.0%, at best), while all-in (inc. performance fees) they’re earning over 2.0% of AUM. And two-thirds of AUM’s focused on Technology & Japan, two potentially interesting investment themes I might like to access via a specialist manager.

That leaves 2 more stand-outs: The first is Cowen Group. What, oh what, have those b**tard investment bankers done here..?! There’s a valuable & growing alternative manager business (Ramius) embedded here, with $10.2 bio of AUM. However, the investment banking hogs at the trough completely obscure that. And the P&L’s a nightmare to distinguish between actual business losses, investment asset gains/losses, non-cash expenses etc. There seems a complete inability here to control compensation, and therefore losses, but there’s still plenty of net cash/equity on hand. Sure, their investment banking business may start to boom, but they’ve had that fond hope for a few years now – time to slash & burn! If the ship’s righted, there’s an easy 100-150% of upside here.

And last we’ve Man Group. Sigh… What’s happened here? Man’s like a TBTF bank now – a great business (GLG Partners, in this instance), sullied by a black-box business (AHL). And the rot set in a long time ago – reminds me of a duck gliding by, everything was still looking good above-surface but (down below) the paddling became increasingly frantic. In Man’s case, they lunged for salvation through acquisition. While GLG Partners is a marvelous hedge fund firm, their acquisition by Man never made much sense. Then Man purchased Ore Hill, and yesterday we see them adding another $8.0 billion of AUM through the acquisition of FRM Holdings!

Years back, their greed on fees was the first big warning sign for me. Even now, despite a tough year or two, fees are at 2.43% of AUM. btw I’m just talking about management fees! In a really good year, performance fees would jack this up north of 5.0% of AUM… And the acquisitions actually diluted fees, which used to be at a 3.0%+ level. I didn’t see what was coming for Man – but I’d no interest in betting on such unprecedented fees being maintained long-term. And I certainly don’t think they’ve earned (for years now) the returns needed to really justify those kind of fees. In fact, I suspect any inherent performance advantage they had walked out the door when David Harding (the H in AHL) left to form Winton Capital.

Their continued success afterwards just highlights the strength & power of a truly remarkable sales & marketing organization. But I think that’s also their ultimate weakness… I always got the feeling all management ever discussed was sales & redemptions, not performance (unless it was negative, of course, as is now the case)! Anyway, I could never figure out how to evaluate/buy into AHL as an investment theme. It’s a true black-box business and, like the banks, the market’s love affair is now well & truly over. Analysts are now relying on M&A values as a back-stop – we’ve even heard the ludicrous suggestion Man’s only worth its liquidation value!

This highlights a serious industry problem – the banks were deep-pocketed buyers for years. For obvious reasons (not least the Volcker rule), these buyers are now gone – for years to come… Man rumours circulating (even some months ago!) that JP Morgan (JPM:US) would acquire them were patently absurd! I’m sure we’ll hear from the media about all these ‘missing buyers’ at some point, but I suspect it’s already baked into the sector’s under-valuation.

Yes, there’s significant Man upside from current levels, but I’m still uncomfortable with AHL & the business focus/model. If only GLG comprised the majority/all of AUM, I’d dive right in! I guess this illustrates again that assessing all opportunities in a sector shouldn’t prompt one to automatically load up on the highest upside potential stock(s). Of course not! The greatest upside is inevitably offered by the most difficult/opaque/risky stocks & companies. Sure, one of these stocks is worth a bet occasionally, but usually (by comparison) a superior stock/company with just half the upside potential will still offer the better risk/reward proposition…