After unquestioned dominance since the collapse of the Soviet Union, capitalism has come under attack in the past 5 years. The public has lost a little faith in the markets, and understandably so.
Greedy “Fat Cats” made a mess of the mortgage industry and brought the national and world economy to its knees. Checks and balances were bypassed by incompetent or complicit ratings agencies; the worst of human qualities put on display by the brokers, bankers, and market makers up and down Wall Street – and Main Street certainly likewise partook in the greedy grab.
But the world economy survived and the seeds of prolonged recovery are truly blossoming. The housing sector is rebounding after five long years of pain; unemployment slowly and steadily moves back downward toward 5%; corporate earnings are 35% higher than 2007, balance sheets are cleaner than in a generation’s time, and the public equity markets are nearing all-time highs.
And with this blossoming recovery we note the return of the fast moving, complex, and headline grabbing deals that make Wall Street so well known. -The Flaneur
Wheelin’ and Dealin’ – The Return of High Profile Deal Making
After five years of volatile and uncertain times in mergers and acquisitions (M&A), private equity (PE), and leveraged buyouts (LBO), we recognize the recent high profile, large scale transactions in the capital markets as a watershed moment, marking what will be a return to the traditional high performance in the high finance industry.
Recent events in the news and macro-economic data both point to a resurgence in global deal making. To capitalize on this, we are recommending two global players in capital management services and investment banking that are both appropriately aligned with the trend and also well suited to mitigate ongoing risks in the industry.
The headlines have been awash in announcements of high profile mergers and acquisitions of late. First with the highly covered plan to take Dell (NASDAQ:DELL) private through a leveraged buy-out, followed soon thereafter with news that the two major office supply retailers, Office Depot Inc. (NYSE:ODP) and OfficeMax Inc. (NSYE:OMX) in the US are in merger talks.
Warren Buffett still talks about his “elephant gun” even after announcing the purchase of Heinz Corp for $28 billion dollars. American Airlines is in late stage negotiations to merge with US Airways in an $11 billion deal. And Liberty Global Inc. recently announced plans to acquire Virgin Media Inc in a $23.3 billion cash and stock deal.
We anticipate more and more high profile, media grabbing headlines in the next 12 months. With the cost of capital at historic lows (which has continued to benefit US Manufacturing and the build out of energy infrastructure), we anticipate this surge of media coverage to spur a shift in attitude, bringing both buyers and sellers off the sidelines, spurring a boom in M&A, IPO, LBO, and other capital markets activity.
Drivers of Current Industry Performance – Size Matters
As the charts below demonstrate, the hold period for private equity-owned companies has surpassed 5 years for the first time. Many funds are starting to feel pressure to return capital to limited partners (LPs – the investors in the funds that PE firms manage).
At the same time, fundraising volume has gone up while the number of new funds has gone down. This means more big funds are being raised likely at the expense of the smaller funds and smaller firms. If the big players are still able to raise funds, they’re presumably feeling less pressure to return capital to LPs, and therefore they can be more selective as to when to sell their investments (and in turn boost their rates of return).
Anecdotally, via middle market bankers we’ve spoken with, many smaller funds are beginning to feel pressure from their LPs to return capital. Furthermore, LPs in these funds have opportunistically and increasingly requested direct co-investments. That is, LPs have agreed to honor standing fund commitments but have also requested the ability to directly invest part of their equity outside of the “managed” structure, which reduces fee income to the PE fund. This seems to mark a turning point – the individual exhibiting leverage over the longstanding, unchallenged institution. However, this does not yet seem to be an issue for the mega funds, who enjoy stronger brand recognition and tend to deal with largely institutional LPs, such as pension and endowment funds.
Further, recent trends demonstrate an increase in the use of debt in these transactions. Typically, large funds will attract even more debt as their size is widely seen to mitigate risk. More debt reduces equity capital required, boosting return on equity.
The big, multi-billion dollar, diversified players are better equipped than smaller firms to play multiple roles in transactions: advisory, equity, senior lender, and/or mezzanine lender. With the return to higher debt levels in transactions and a pickup in overall deal volume, we see the overall deal pie growing, and as such, we recognize that the big firms are better able to capture more of that pie. The trend of smaller players declining while “mega funds” proliferate has already begun, and we expect it to continue.
Volatility and Global Exposure – Necessary Differentiators
The data shows two key traits for consistent, above peer performance: the ability to weather volatility and global exposure. This chart, sourced from Ernst & Young, clearly shows the volatility and uncertainty that has pervaded the markets since 2008.
Further, the near term VIX index, a common measure of implied volatility in the markets, again shows how unpredictable the capital markets have been over the past 5 years.
We recognize this volatility as a continuing concern in the markets, and we anticipate the trend to continue for the foreseeable future. As such, we consider it to be absolutely critical to invest in firms with sufficient diversity in their capital market exposures to weather these short term spikes.
While the high profile deals on the front page of the Wall Street Journal are almost always companies based in New York or Europe, the real growth in the industry is taking place in China, Taiwan, Hong Kong and Southeast Asia.
From the same Ernst & Young report, it’s clear that the IPO market is being driven significantly by activity in the Asian-Pacific region.
There are two primary stories in the world economy today. There is high growth in the emerging markets, primarily driven by increasing domestic demand in the greater Chinese areas. And there is slow growth and uncertainty in the western economies. The world is not in a recession, and we do not anticipate it falling into one (though we acknowledge others may disagree). However, it is clear that to find opportunities to put money to work on a global, diversified scale, capital must participate in the high growth environment in Asia and other emerging markets.
The capital markets are a highly regulated industry, from retail securities to private equity to hedge funds, and we anticipate that regulation to increase, especially for traditional banks. As such, our recommendation to play the wave of high finance transactions and other deal making is not through traditional banks, but instead through diversified money managers Blackstone Group (NYSE:BX) and KKR (NYSE: KKR).
Blackstone Group is a premier global asset manager. The company has a diversified business, with businesses in M&A, Private Equity, Credit products, Hedge Funds, Real Estate, and other related sectors. 2012 year end GAAP revenues were $4 billion with over $1 billion in distributable earnings (a 48% increase over 2011). Fee related earnings were up 28% over 2011 to $700 million as assets under management increased $44 billion (26%) to $210 billion. This growth was driven by $47 billion in capital inflows of which $19 billion was invested in new fund strategies. Blackstone’s funds returned $18.5 billion of capital to investors in 2012. The scale of this performance is staggering, and is indicative of the diversification and globalization of this company.
Further, note the increase in total Assets Under Management in Q4 versus the Fee Earning Assets Under Management. This is a reflection of capital inflows that have not yet been put to work. This can be viewed as dry powder that will be deployed in the coming month, driving fee income even higher.
Further, BX is well positioned to handle changing market and macroeconomic issues with $2.3 billion of cash and liquid investments and a $1.1 billion undrawn revolving line of credit.
BX is currently trading near its 5 year highs. We see this company as poised to break through that resistance and continue the trend higher.
KKR & Co. L.P. is another global, diversified capital management firm well positioned to take advantage of a more active and higher profile capital market environment. With $76 billion assets under management, KKR is considerably smaller than BX, however, it is still quite high performing, global, and diversified.
KKR is traditionally a private equity player and the company’s assets under management reflect that concentration. However, the fund segmentation within the PE business is diversified geographically (with funds targeting North America, China, Europe, Asia, and others), by industry, and by asset class (equity, commodities, mezzanine finance, and debt finance).
KKR posted GAAP revenues of $560 million for year end 2012 while returning over $9 billion to investors in private equity and co-investment funds. GAAP net income was $561 million with fee related earnings of $319 million. The bellwether in these numbers, though, is assets under management at $76 billion, a record for KKR and an increase of 28% from year end 2011.
Similar to BX, KKR is currently testing its 5 year high. For the same reason we recommend BX, we also see KKR breaking through that resistance and appreciating to new all-time highs.
Of course, there are risks – the global economy could slow, the end of quantitative easing programs in the US could sidetrack the markets to the detriment of private capital managers, “currency wars”, the fiscal cliff, European Union issues, and other macro trends could derail even the most powerful locomotive.
This analysis is a macro play on the continued recovery and strengthening of the global capital markets via two international powerhouse companies. Our preference is for Blackstone; however, both BX and KKR are strong plays on the re-invigorated global capital market.
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Disclosure: As of the time of publishing, the author holds no positions in the stocks mentioned herein and does not intend to hold any position in the next 72 hours.