File 026634
Apollo Global Management Investment Analysis and Tax Reform Outlook (File 026634)
Investment analysis memo discussing Apollo Global Management's growth prospects, post-election business outlook, and potential impact of tax reform on the alternative asset management industry.
Summary
An investment research memo analyzing Apollo Global Management's business strategy and market position following a management meeting with Co-Founder Josh Harris and CFO Martin Kelly. The document discusses Apollo's optimistic growth outlook, particularly in Credit and other business lines, while highlighting concerns about potential tax reform impacts including carried interest taxation and corporate interest deductibility. The memo maintains a Neutral rating on APO stock at a $21 price target, emphasizing that distributable earnings growth will develop over time but Fund VIII presents attractive long-term carry potential.
We recently met with Apollo's management
We recently met with Apollo Co-Founder Josh Harris and CFO Martin Kelly, who were optimistic about the growth opportunities for the firm and the recurring fee outlook, although they expect meaningful upside in DE (distributable earnings) to take time given seasoning of funds. While it is too early to have a clear view on the potential tax impact to APO and the sector from a tax overhaul, management is keeping a close eye on all potential scenarios (carried interest tax rate, C-corp vs. PTP with lower corp tax, and interest deductibility). While we are raising our PO to $21 and continue to see attractive growth for APO, given valuation and muted DE levels, we maintain our Neutral rating.
Post-election outlook for their business
Management sees the election outcome (Trump and Republican Congress) to be likely favorable for GDP growth (portfolio company EBITDA trends), with the potential for rising rates and inflation to eventually create some volatility and uncertainty on multiples. In addition, potential de-regulation could create more competition in some areas that the alternative asset managers have expanded into over the last few years, although the team still sees ample opportunity for growth.
Potential tax changes a mixed bag
There are three primary tax items that could potentially impact APO and the industry. First, the tax rate on carried interest could go higher, which would increase the tax rate on carry for employees and on a portion of the distribution for some unitholders (this has generally been expected at some point, given bi-partisan support). Second, if the corporate tax rate is reduced to 15-20%, this could create an incentive for firms to shift from a partnership structure to a c-corp structure, which would simplify the tax issues and entertain a larger investor base (including possible index inclusion). Finally, if the corporate tax rate is lowered, it has to be funded with an offset to have enough support and, as of now, the primary item being considered is the loss of corporate interest tax deductibility, which would be a significant negative for the sector. Given the pros and cons and it being very early in the process, there is no clear cut view, but tax reform will be an important item for the industry moving forward.
Attractive growth and FRE outlook ahead
Management sees the growth outlook as attractive, particularly in Credit. Apollo has multiple areas to drive double-digit growth, including Athene, Mid-Cap Financial, AAME (Apollo Asset Management Europe) and Total Return. Rising interest rates could be a near-term risk to credit valuations, but APO's overall duration is low or matched, and higher interest rates could benefit yields and make it easier to achieve hurdles in certain products. Longer term, the team wants Real Estate to be more significant. Importantly, with Apollo starting the process for PE Fund IX, the combination of this fund with growth in Credit bodes well for the FRE (fee-related earnings) outlook into 2017-18.
DE will take a bit of time, but Fund VIII looks attractive
The outlook for DE is favorable with rising FRE, but the real lift will be driven by carried interest over time. The key fund to drive meaningfully higher DE is Fund VIII and, while still early in its life cycle, given its strong performance, the outlook into 2018-20 is attractive. We estimate that Fund VIII could return more than $2.0B of cash carry for unitholders, or around $5 per share, assuming a 2.0x MOIC and typical compensation.
Michael Carrier, CFA