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.
Citigroup: A Bet Against the End of the World
Sep/112
This is the first of a three part posting on Citigroup. The second part compared the opportunity in Citigroup to Bank of America. The final part will review a list of reasons why investors avoid Citigroup and how I overcome these objections.
Betting on the End of the World by shorting the major U.S. banks is not a winning strategy. This is not to say investors should blindly depend on policy makers to bailout the financial system every time there is an issue. We have clear, recent evidence from September 2008 that bailouts do not always come for investors. Also, I fear we will have a repeat of September 2008 in the future as anti-bailout proponents continue to gain power in Washington. However, the current financial policy makers (Geithner and Bernanke) will not repeat the mistakes of September 2008, so shorting the major U.S. banks now is a losing strategy.
The sellers of bank stocks at these levels fear the financial system will collapse if there is a hard default by Greece. Their thesis is if Greece defaults, major European banks will take losses directly and suffer additional counterparty losses from the failure of smaller banks. As the European banks take losses, risk aversion will rise and liquidity will drain from the system. Lower levels of liquidity will drive asset prices lower causing losses in both U.S. and European banks. These additional losses may cause a major a European bank to fail, and U.S. banks will suffer additional losses as a result. If the losses for the U.S. banks rise to a high enough level, we may see a major U.S. bank have to fire-sale assets and/or raise capital at dilutive stock prices.
I disagree with several parts of this thesis. Most important, I believe the current policy makers learned an important lesson from September 2008 and will not compound a crisis by letting their financial institutions fail due to a lack of liquidity. Plus, the major U.S. banks have liquidity and capital levels that will allow them to survive a severe downturn in the financial markets. I have been expressing my view by adding to my position in Citigroup.
My preferred way to implement my view that the financial system will not collapse is to own shares of Citigroup. I believe all of the large banks are attractive, including JP Morgan Chase, Bank of America, Goldman Sachs, Morgan Stanley and Wells Fargo. I own most of them, but my largest position is in Citigroup. My preference for Citigroup is due to its low valuation and its ongoing corporate restructuring which is generating excess capital.
I do not think the financial system is going to collapse due to the current European crisis. Political leaders have learned important lessons from the Lehman Brothers bankruptcy that orderly wind-down of major financial institutions is needed. I believe the distress in the financial system in September 2008 is etched on the minds of Geithner and Bernanke. They will not allow a major financial institution to fail due to a shock from Europe.
Treasury Secretary Tim Geithner consistently shows in his speeches and interviews that the lessons learned from September 2008 are well in grained. On September 19th, Geithner said in a Bloomberg interview, “I think you’re going to see them draw on the lessons of our crisis, draw on the lessons of things that worked here in the United States. I think you’ll see that reflected in some of the choices they make.”
In the end, I believe the European leaders have learned these same lessons. They will protect their own country’s banks from losses. It may be bumpy trip, but we see evidence that European political leaders are starting to get it. Merkel and Sarkozy released a joint statement saying that they “are convinced that Greece’s future is in the eurozone.” At the recent G7 meeting, the finance ministers stated their support for the banks, “We will take all necessary actions to ensure the resilience of banking systems and financial markets,”
In addition to the support from political leaders, I believe Citigroup is approaching a potential Greek default with much more solid liquidity and capital positions than. Here’s a look at the high level numbers:
| Dec 2007 | June 2011 | |
| Cash as % of Assets | 10.2% | 16.7% |
| Reserves/Loans | 1.9% | 5.3% |
| Deposits/(Loans+Securities) | 79% | 89% |
| Tangible Common Equity/Tangible Assets | 1.6% | 7.3% |
These are clearly stronger numbers and position Citigroup to handle a stressful environment better than 2008. In addition, Citigroup has spent the past 3 years reducing risk within its loan book. With the credit quality metrics declining, I get the sense that management has a much better sense of its balance sheet and the risks than it did 3 years ago.
I believe Citigroup is well positioned here to survive a stressful period in the markets due to a Greek default. With the stock at 60% of tangible book value, I believe it is an attractive stock. The reason it is at these low valuation level is the potential for potential problems in the financial system due to a Greek default. I do not believe
Disclosure: Long C, BAC, WFC & MS
Disclaimer: This is not investment advice. This intended to be a window into my thinking when analyzing Citigroup. Please do you own work before making an investment. My positions listed in the disclosure may change without further update.
Make Fannie’s Deal No Worse Than TARP
Aug/090
Given Freddie Mac’s recently report profitable 2nd quarter earnings report, it is time for Treasury Secretary Geithner to amend the terms of Fannie Mae and Freddie Mac’s Senior Preferred Stock Purchase Plan with the Treasury to be comparable to the preferred stock purchases the Treasury made in commercial banks last October under TARP.
Reasons to Change Fannie and Freddie’s Deal with the Treasury
1. Fannie and Freddie should not have a materially worse deal than the banks just because their deal was cut 4 weeks before TARP.
2. Fannie and Freddie are critical to the domestic economy as they have been the only source of mortgage capital for the past 12 months.
3. The mortgage market will need private capital in the future and cannot rely on government support forever, so Fannie and Freddie will have to raise more capital in the future. If the GSEs are going to raise capital in the future, the Treasury is going to have to treat existing capital better than its current deal with the GSEs.
4. Fannie and Freddie incurred higher expenses because they were team players and supported the Obama Administration’s economic recovery plan. Changing their deal would be a small payback for the support they have given the country and the Administration.
5. Recognition that placing the GSEs in conservatorship was a political attack by led by former Treasury Secretary Paulson.
6. Recognition that former Treasury Secretary Paulson caused a decline in the GSEs stock prices by not outlining the terms under which he would provide capital to the GSEs in the July 2008 legislation. Sec. Paulson then used circular reasoning in claiming that the GSEs had to be taken over because they had low stock prices and couldn’t raise capital. In fact, they couldn’t raise capital because he would not state the terms of a potential future Treasury investment.
7. Paulson’s reasoning for the harsh treatment of GSE shareholders was that shareholders had to pay for the poor risks taken by the companies’ management teams. I disagree since many shareholders were giving advice to the respective managements to raise capital and reduce risk. Rich Pzena was the most outspoken shareholder on this point. Plus, Paulson reversed his position on this issue once he was proven wrong with his handling of the Lehman situation and treated the bank shareholders on much more friendly terms.
8. Eliminating the dividend on Fannie and Freddie’s preferred stockholders was a failed experiment on the part of Sec. Paulson and destroyed the new issuance market for preferred stock. It also hurt many small banks that held Fannie and Freddie preferred stock in their portfolios.
9. GSE preferred stock is still primarily owned by small banks. When dividends are restored, the value of the preferred stock will increase by 10x. This will add approximately $30 billion in restored capital to the commercial banking industry. If banks levered this capital 12x, this raises industry lending capacity by $360 billion.
10. The losses by the GSEs since entering conservatorship have been inflated because a) they are mostly write-downs of deferred tax-assets which the companies still retain and b) the credit reserve build was bigger than expected because Sec. Paulson sent the economy into a tailspin by not providing an orderly wind down to Lehman Brothers.
Terms to Change
1. Lower Preferred Stock Coupon to 5% from 10%. There is no justification for the GSEs to pay a higher coupon than the banks.
2. Change the Treasury’s warrant from 79.99% of the GSEs’ equity to terms identical to the warrant deal received by the banks under TARP. Similar to the preceding point, there is no justification for the GSEs to give the U.S. a higher equity stake for than the banks did.
3. Make the Treasury’s preferred stock pari passu with existing preferred stock. This is another move to equal the banks’ deal under TARP
4. Eliminate asset size restrictions on Fannie and Freddie’s mortgage portfolios. This provision proves my Republican conspiracy theory for placing the GSEs into conservatorship. There is no reason to shrink the GSEs at this point. We need the GSEs to expand their balance sheets. The Fed has temporarily stepped into the breached left by the GSEs not growing. But, what is going to happen when the Fed steps back from the mortgage market? We need the GSEs to support the market as the Fed reduces its balance sheet.
The GSEs deal with the Treasury Secretary should be updated to be similar to the deal the banks received under TARP. Based on the nobler GSE housing mission, there is an argument that they should be treated better than the banks. The banks have no legs to stand on because the FDIC insurance they receive from the federal government is a larger subsidy than the implicit guarantee Fannie and Freddie enjoy.
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