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April 20, 2017
We own Ares Management. Ares Management is a Los Angeles-based alternative asset manager that alumni of Apollo Management founded in 1997. Ares specializes in direct private lending, but the firm also has significant private equity and real estate platforms. Ares Management is the third-party manager for the largest publicly-traded business development company (BDC), Ares Capital Corporation (ARCC).
Here is our investment thesis on Ares Management:
- We Favor Alternative Managers over Traditional Asset Managers - We also own several other alternative asset managers (Blackstone, KKR, Carlyle & Colony) because we like the tailwinds and structural growth characteristics of this sector. a. Institutional portfolio allocation tailwinds - We believe large institutions are approaching investing with a barbell strategy. On the one hand, institutions are shifting away from active management to passively managed index funds. To complement the passive strategy with public securities, they are allocating a higher and higher proportion of their portfolio to alternative funds. b. Alternative Managers have more stable AUM – Alternative managers have a high proportion of their AUM in long-lived or permanent capital structures such as private equity funds where the manager decides when to monetize investments and return capital to investors. Ares also has a significant proportion of its AUM in permanent capital structures such as Ares Capital Corporation. In a permanent capital structure, the investor can never redeem from the fund, so Ares Management’s revenue base is more stable due to the permanent capital. If the investor wants to exit their position in a fund with permanent capital, the investor must sell their investment on the secondary market.
- Ares is a Leading Alternative Credit Manager and Alternative Credit has tailwinds – Alternative credit is direct lending outside of the banking system. With $60 billion in AUM in Alternative Credit, Ares is a leader in this area. Alternative credit is growing as continued low-interest rates drive investors to seek higher yields and banks are exiting certain lending segments due to increased regulation.
- Attractive Growth of AUM a. Attractive Performance Track Record – Ares has attractive performance track records across each of their investment platforms. We believe the track records and their investment process will allow them to continue to raise additional AUM. b. Smaller base allows for higher growth rates – Over the past ten years, Ares has grown AUM at a 21% compounded annual growth rate (CAGR). Since its IPO, the growth rate has been slower but has reaccelerated this year.
- Operating leverage – Ares Management demonstrated operating leverage over the past year as Management Fee revenue increased 12%, but Fee Related Earnings increased 28%. With margins moving from 26.7% to 29.7% over the past year, we believe margins can continue to expand into the low 30s%.
- Step-up in fees due to ACAS merger waiver – To support the Ares Capital acquisition of American Capital, Ares Management agreed to waive $10 million of quarterly management fees through Q3 2019. When this waiver expires, Ares Management will have a 10% step-up in earnings per share. We think this is exciting because we expect regular earnings to grow in addition to this pending increase.
- The potential for increased incentive fees – With each successive fund, Ares raises more money. For example, Ares’s latest private fund was 50% larger than its predecessor. These larger funds increase the potential for Ares Management to earn larger incentive fees. Ares has increased the amount of its incentive eligible AUM by 50% over the past 24 months.
- Valuation – Ares Management has a market capitalization of $4 billion and trades at 10.3x 2018 estimated earnings per share (EPS). a. Not expensive compared to Asset Managers - Traditional asset managers trade at a median 13.9x 2018 EPS. However, traditional asset managers are facing threats from passive indexing and exchange-traded funds that Ares is not facing. b. Not expensive compared to banks –Banks with market caps between $3 and $6 billion trade at a median 14.9x 2018 EPS. Ares is a better business than the average regional bank. Ares grows faster than do typical banks, and it does not operate with significant leverage like a bank. Ares also does not need to retain capital to grow because like other asset managers it provides a service for a fee. c. Not expensive on Sum-of-the-Parts basis – We believe Ares Management is worth $26 on a sum-of-the-parts basis (SOTP). There are three components to our SOTP: Fee Related Earnings, Incentive Fee-Related Earnings, and Net Balance Sheet Assets. We believe Fee Related Earnings will be $263 million in 2018 or $1.30 per share. We apply a 15x multiple to Fee Related Earnings or $19.60 per share. We think Incentive Fees will average $120 million. At a 7x multiple on Incentive Fee Earnings, we value the stream of future Incentive Fees at $3.90. Lastly, Ares Management has net assets on its balance sheet of $2.30. d. Total Return Potential – Since Ares Management does not need to retain capital to grow, at the current 10x multiple, it could payout all of its earnings for a 10% yield and grow AUM at the recent 9% rate and have high-teens returns for a long time. Plus, the management team could always enhance this potential return through acquisitions.
- Management is aligned with shareholders and has solid track record – a. Management owns 70% of Ares stock – We always prefer to invest in companies with high insider ownership. Ares’s management team owns about 72% of Ares. b. The potential for Inorganic Growth – Ares Management has a track record of building their business through smart bolt-on acquisitions. Ares Management acquired EIF, an energy-focused private equity manager, in 2015. Their BDC, Ares Capital, has acquired two other BDCs, Allied Capital in 2010 and American Capital in 2017. Ares Management benefits from these acquisitions as their management fees increase with the size of Ares Capital. We believe Ares’s management team is always looking to grow through smart acquisitions.
- Tax Reform - If Congress lowers the corporate tax rate to 20%, we believe that Ares’s management would seriously consider converting to a C-Corporation from a publicly-traded limited partnership. We believe this would improve the value of Ares’s stock price because the increased multiple would more than offset the lower earnings due to corporate taxes paid.
- Performance – Ares Management’s franchise is at risk to poor performance. However, this is not a current issue for the company. Ares has strong performance across each of its investment platforms. Longer-term, this will always be a threat to Ares.
- Less growth from market appreciation than a traditional asset manager – Because Ares’s investment platforms either pay current income or return capital when they harvest investments, Ares’s AUM does not benefit from market appreciation like a traditional asset manager. Ares’s growth of AUM will mainly come from raising larger successor funds.
- Ares Management trades for a discount for some reasons that may persist a. Ares Management is not as well-known as the other alternative asset managers. b. Ares Management has a small float of available stock. Only about $1 billion of the shares trade, so large investors may find difficulty buying and selling normally sized positions. In our experience, this factor prevents several potential investors from performing the required due diligence since they know that they’ll be unlikely to acquire a position without impacting the stock price.c. Ares Management is a publicly traded partnership, so investors in the stock receive a K-1 issued by the company on an annual basis. Receiving a K-1 prevents many investment managers from buying Ares’s for their separate account clients because of tax complications. d. Another drawback of being a publicly traded partnership is Ares is not eligible for inclusion in the major indexes. So, Ares stock is not held by many exchange-traded funds.
Disclaimer: The discussion of any security is meant solely as an illustration of our investment and thought process and should NOT be considered as a recommendation or suggestion to buy or sell any securities. Before you make any investment, do your own research and talk to your own financial adviser. Information in this report is received from external sources. Therefore, we can make no guarantee as to the completeness or accuracy of the information provided.