Alternative asset managers have become more popular in the last few years, but with a different mandate than traditional AMs that allows them to invest across investment cycles, normal valuation methods may not give an accurate sense of the alt’s potential for growth.
Carried interest more than half alternative asset managers’ pretax income
“With volatile and less predictable earnings, the market has been reluctant to assign a comparable traditional asset manager P/E on the Alts’ carried interest income stream,” writes Deutsche Bank analyst Brian Bedell.
Earnings from fees are being valued at higher multiples than carried interest, even though carried interest accounts for a majority of Alt’s pretax income and more reliably translates into cash distributions down the road.
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“We prefer to value the Alternative asset managers on longer-term ‘distributable earnings’ (DE), which is a proxy for cash flow and the basis for cash distributions to unit holders,” he writes.
Under this different valuation method, the major alt managers trade with a median 12-13x PE, considerably cheaper than the S&P 500 (INDEXSP:.INX) or most traditional asset managers. Bedell argues that other investors will migrate to this method instead of the GAAP-like economic net income (ENI) valuations currently being used over the next few years, opening up room for multiple expansion and makes this expansion an important part of his investment thesis, adding another component of risk to this asset class (since other investors may be perfectly happy with the current method).
Secular growth with a cyclical bonus
“The secular case is simply that the alternative asset managers (and particularly in private equity) have an inherent and defensible competitive advantage in being able to invest through cycles – picking attractive entry and exit points, while being able to influence the outcomes of their portfolio companies,” writes Bedell.
Many of the large alternative asset managers are former private equity firms, and they are still able to take a longer perspective than many traditional asset managers can manage while keeping their investors happy. But as long as the recovery holds, this should also be the part of the investment cycle when alts benefit from all their hard work.
“Conditions for portfolio position exits via IPOs, secondary offerings, and M&A, for example, should remain relatively favorable,” Bedell writes.
Deutsche Bank is initiating coverage of five alternative asset managers with The Blackstone Group L.P. (NYSE:BX), The Carlyle Group LP (NASDAQ:CG), and Oaktree Capital Group LLC (NYSE:OAK) all rated as Buys. BX is the bank’s top pick with a price target of $39.