Are Private Equity Firms as Volatile as Their Stock Prices?
Oct/113
This post about private equity business franchises originally ran on MarketWatch.com on October 11, 2011.
Publicly traded private equity firms KKR & Co, The Blackstone Group and Apollo Global Management declined more than the overall financial sector during the 3rd quarter. It appears that investors had concerns that these firms would suffer from liquidity drying up in the financial markets and hurt values realized on their existing investments.
I believe private equity firms’ business franchises don’t change in value as much as the volatility of their stock prices would predict. When these firms’ stocks sell-off on fears that their existing portfolios are declining in value, I believe there is an opportunity in their stocks.
The Blackstone Group BX has proven to be a volatile stock. BX opened for trading at $36.60 on June 22, 2007. Less than 2 years later, it had fallen 90% when it hit $3.55 intra-day on February 27, 2009. BX then climbed 450% to a recent high of $19.49 in April 2011. Since April, it has declined another 43% on the broader market sell-off.
During this time, I would argue that the value of Blackstone’s business franchise has not been nearly as volatile as the stock price. Here’s a chart showing Blackstone’s fee-paying assets under management since coming public. As you can see, Blackstone’s assets under management have increased 76% since coming public in 2007 with little volatility.
Chart: Gator Capital; Data: Blackstone SEC Filings
I would argue that investors place too high a value on the immediate prospects for exiting the firms’ current investments. While exiting investments and recording incentive fees on these investments is an important part of the income stream, there are times when these stocks sell off to such low levels that they are good values, even ignoring any future incentive fees. Currently, Blackstone trades at 15x the 2012 estimates made by Oppenheimer analyst Chris Kotowski for Blackstone’s earnings only from its management fees. At its February 2009 lows, Blackstone traded at just 9x its 2009 management fee-only earnings. (Source: Oppenheimer note 9/6/11 “Resetting for the New World Order”)
In thinking about a private equity firm’s business franchise, I believe the value of the firm lies in its ability to continue to raise additional funds from investors. This fund raising ability is affected by past absolute and relative performance of its investments, its reputation, and its personal relationships with its clients. When the stock market declines, only the absolute performance of a private equity firm’s investments declines, but it does not quickly affect the other factors that predict a private equity firm’s fund raising ability. Blackstone has demonstrated a strong ability to raise assets since coming public. I would argue that its ability to raise assets demonstrates its business franchise has increased in value.
The other part of investing in private equity firms that is often missed in stock market declines is the increased investment opportunities these firms have. Unlike their investment banking peers, when liquidity gets tight, private equity firms have dry powder to make new investments. Plus, they do not become forced sellers like Bank of America BAC +0.94% was in selling its private equity stake in HCA a few weeks ago. Of course, private equity firms may not be able to use as much leverage as they could in a more liquid capital markets environment, however the declines in investment prices may offset the lack of leverage in these new investments.
The current sell-off in the stock market is presenting a second opportunity to buy the publicly traded private equity firms. I believe the stocks of these firms are more volatile than the underlying business franchises. The volatility comes from investors focusing on realizing value from the firms’ existing portfolios. Instead, I’ll focus on the private equity firms’ ongoing franchise values as measured by their ability to raise money for new funds they offer.
Disclosure: Long KKR, APO, BX
The commentary does not constitute individualized investment advice. The opinions offered herein are not personalized recommendations to buy, sell or hold securities.
Short-Term Opportunity in FFBC Warrants
Nov/100
There is a short term trading opportunity in First Financial Bancorp warrants (FFBCW). A large holder of FFBC warrants is liquidating his stake. FFBC reported a good 3rd Quarter and the stock is rising, but the price of the warrants is flat to down as the holder sits on the offer side of the market. I estimate this large holder has sold ½ to 2/3 of his position. He could finish selling his position Monday or Tuesday. After he is “cleaned up” I would expect the price of these warrants to recover to higher implied volatilities.
The large holder of FFBC warrants could be Castle Point, which is run by Todd Combs. Combs was recently hired by Warren Buffett to run a sizeable portion of Berkshire Hathaway’s investment portfolio. Combs is liquidating Castle Point. According to Castle Point’s 13-HF filed in August, Castle Point owned 304,917 FFBC warrants. There are only a total of 465,117 FFBC warrants outstanding. Castle Point owned 65.56% of the issue!
I estimate Castle Point has sold most of its holdings of FFBC warrants. Since the announcement of Buffett’s hiring of Combs, the volume of FFBC warrants traded has risen substantially. The total FFBC warrants traded since the October 22nd announcement is 220,697. Assuming that a very high percentage of these were sold by Castle Point, the firm could be as much as 50% or 2/3 done selling its position.
I expect the warrant’s price to return to higher implied volatility once Castle Point has completed its selling. Below is a table showing FFBC’s stock price, warrant price and warrant implied volatility on different dates. The first date was June 2nd, which was the date when bids were due in the Treasury auction of FFBC warrants to the public. The next date is September 30th, which was the most recent quarter end and a day when some volume of FFBC warrants traded. The last day is last Friday, November 5th.
| 6/2/10 | 9/30/10 | 11/5/10 | |
| FFBC Stock Price | $15.87 | $16.68 | $17.69 |
| FFBC Warrant Price | $6.70 | $7.65 | $7.00 |
| Days to Expiration | 3084 | 2964 | 2928 |
| FFBC Warrant Implied Volatility | 40.69% | 43.65% | 34.91% |
In the table, we can see the current implied volatility of the warrants is lower than it has been on the previous dates. I believe once Castle Point is doe selling its position that the implied volatility of the FFBC warrants will slowly rise back to somewhere in the low-40’s. If I am correct, a low-40’s implied volatility at the current stock price would imply that the warrants would rise between $1.00 and $1.50. This would be a 14% to 21% increase in warrant value.
My suggestion is to wait on the bid side of the market and let the large seller push the price down to your bid. If the seller does not hit your bid in the next two or three days and volume of the warrants approaches 100,000, then you may want to get more aggressive with your bid. Once the large seller is done liquidating his position, I expect the volume of FFBC warrants to decline materiallyand will be difficult to buy. It is possible that future traded volume will be higher than it was prior to the Castle Point liquidation because the outstanding warrants will be held more widely. Another consideration is hedging your warrant purchase to protect against the stock declining. FFBC has rallied since reporting a decent quarter last week. It is not clear whether the rally will continue or if the recent price move was blip. I would argue the recent rally in the stock has allowed the large seller to exit his position for a decent nominal price even though the relative value price based on implied volatility is low.
Disclaimer: This is not investment advice. Investing in warrants is risky. Please see your financial advisor for independent investment advice. I do not have first-hand knowledge that Castle Point is responsible for the recent selling of FFBC warrants. I have used the mosaic theory to make my conclusions based on Castle Point’s SEC filing, Berkshire Hathaway’s press release, articles in the Wall Street Journal, and volume data from the NASDAQ. If you first read this post after November 9, 2010, the opportunity in FFBC warrants is likely gone.
Disclosure: Long FFBCW
You Don’t Want Berkshire to Pay Dividends
May/090
This year Carol Loomis asked the question whether Berkshire should start paying dividends since the stock price hasn’t risen in 5 years. This was in reference to Buffett longstanding quote that he will pay a dividend when he thinks he can’t create at least $1 of market value for each $1 of retained earnings. Jeff Matthews refers to this as a question that Buffett avoided answering in this thought provoking blog post.
My opinion is who cares whether Buffett answered the dividend question. If you are even asking the question, you should sell your Berkshire stock. The reason to own Berkshire is to get access to Buffett’s capital allocation decisions. Based on his well-documented track record and his well-know thought process, most Berkshire investors think Buffett can make better investment decisions and/or has access to better investment opportunities than they do. The last thing Berkshire investors should want is to have Buffett return the cash back to them in a taxable transaction. Then, the investors will have to decide how to allocate the returned cash.
Historically, investors have wanted management teams to pay dividends because they don’t trust management to spend the free cash flow from the business wisely. The business may be not need capital reinvestment, like Coca-Cola, or it may be a business in secular decline where the best thing to do is harvest the cash rather than reinvest. Shareholders of these businesses probably want managements to pay dividends to make sure they don’t destroy value.
Since the main reason to own Berkshire is to get access to Buffett’s capital allocation skills, if an investor wants Berkshire to pay dividends, then they should sell the stock instead because they obviously don’t believe in Buffett’s ability to create value by allocating capital.
There is a scenario where it makes sense for an investor to want Berkshire to pay a dividend. Maybe an investor thinks Buffett destroys value but think Berkshire is so undervalued that they can make a return by owning the stock and getting him to change his dividend policy. I don’t think Berkshire is anywhere close to a valuation level where this would make sense. At $91,500 per share, Berkshire trades at 1.4x tangible book. It would have to trade below tangible book value for this strategy to make sense.
The reason to invest in Berkshire is get access to Buffett’s skills as a capital allocator. If you want him to pay a dividend, you shouldn’t own the stock. You should ignore the 5-year rolling test about whether he adds more $1 of value for each $1 of retained earnings. He is never going to pay a dividend because he’ll never admit that he can’t add value. If he ever does decide to pay a dividend, you won’t want to own Berkshire.
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