Thursday, November 15, 2012

A Quick Lesson in Private Equity: Dig Beneath the Headlines

A Quick Lesson in Private Equity: Dig Beneath the Headlines

Apollo Global Management just announced that it is going to raise a new private equity fund with a target of $12 billion.  The firm is a value-oriented alternative manager that invests in real estate, credit, and private equity.   Apollo’s new fund is a great opportunity to get some sense of how private equity markets a new fund to clients.  The chart below represents Apollo’s historic private equity record.  It is clear that Apollo is going to tout two statistics: the 35% gross return achieved in Fund VII and the average gross return of 39% achieved by Apollo since 1990.   The marketing goal is for investors to think they’re going to achieve big returns.  Indeed, there’s evidence that Apollo has had some sterling successes (e.g. Fund V in 2001 and their earliest investments in 1990-92).

Private Equity Track Record: Apollo Global Management
as of September 30, 2012

Why are they raising another fund?  Apollo is running out of fresh capital, as they’ve invested $13.2 billion of the $14.5 billion they raised in 2008 (second line).  They have a natural resources fund (ANRP), but it is specialized and relatively small, so they need a new private equity fund to keep their senior partners and owners happy.  Moreover, if they don’t raise a new fund, their fees are going to drop next year, because Fund VII is probably on the verge of charging a fee based on the value of remaining assets instead of committed capital.

Organizational Construction (1995)

Should you be impressed by the 35% gross return on Fund VII?  It’s a good lucking number, but you need to take it with many grains of salt.  First, it's a gross number.  By the time you subtract fund expenses and carry, the number is 26%.  In other words, 9% of the return was eaten up by costs and incentives.  Second, for most of the period since this fund was raised, the stock market has been going up.  We don’t know exactly when Apollo made the investments in Fund VII, but it’s safe to assume stocks were up about 15% during this period.  Nonetheless, the fund appears to have beaten the market.  However, we don’t know how much risk the fund took relative to an investment in stocks, so we need to qualify this conclusion. 

There’s an even bigger caveat that applies to the 26% number.  If you look across the line for Fund VII, you’ll see that  $8.2 billion has been realized, but $13.5 is still unrealized.  This means that 63% of fund’s total value is based on estimates.   Estimating the value of private companies is highly imprecise.  We’ll only know the real value of these investments when Apollo eventually sells them.  Since Apollo is trying to impress prospective investors, I’d be willing to bet that these estimates are a tad optimistic in order to make the returns look rosier.  Think of these unrealized estimates like a favorable appraisal on Antiques Roadshow.  It’s exciting to hear that a family heirloom might be worth x.  However, you don’t really know what it's worth until you try to sell it.

Even if Apollo doesn’t achieve 35% gross or 26% net when Fund VII is fully realized, shouldn’t you be pretty excited about someone who can produce anything close to these returns?  Excitement is going to get you in trouble.  Take a closer look at Apollo’s track record.  It’s pretty inconsistent. Funds III, IV and VI don’t look anything like Funds V and VII.  In other words, there’s a great deal of variability.  If you invest in the new Fund, you might get a 25% return, but you could also get 8% or 9%.  What you might wind up earning in Fund VIII is largely not in Apollo’s control.  If market conditions are as favorable for buying companies as they were in 2008-2009 (lots of distressed assets), the fund might be successful.  On the other hand, if the timing is poor, the results could be mediocre.  All we know is that the partners and owners of Apollo are going to do well, no matter what.

What’s the most impressive part of the Apollo track record?  I think it’s the 8% net return achieved on Fund VI, which was raised in 2006.  Just before the bubble burst, the fund probably made a bunch of investments that suffered through the credit crunch.  It looks like Apollo has managed to make something of these investments.  But there’s a big caveat to this conclusion as well.   Two-thirds of the value of Fund VI is still unrealized, which means the 8% return is dependent on Apollo actually realizing at least $10.5 billion in value on these investments.

Will institutions invest in Apollo’s Fund VIII?  Undoubtedly.  The firm is a well-established player in alternative investments with a credible track record.  They have deep economic, social, and political connections to people who make decisions on behalf of pensions and endowments.  If the investment doesn’t work out, investors will have plenty of well-recognized company.  It’s easier to wipe egg off your face if many others are having to do the same thing.

Would I invest in Apollo Fund VIII?  Let me ask you a question.  What do you think I would do?

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