The Best Business To Own, Leaving The Question Of Price Aside
“Leaving the question of price aside, the best business to own is one that over an extended period can employ large amounts of incremental capital at very high rates of return.” – Warren Buffett
I first wrote about Brookfield Asset Management (BAM) eleven months ago. At the time, I highlighted the quality and track record of Brookfield’s management team. That remains a strength of the company today, but largely because of the way management has evolved the structure and business model into its present-day form, including the asset management business. The asset manager business is the best reason to own Brookfield and could make or break an investment in the company longer term.
Traditionally an owner and operator of real assets, Brookfield’s earlier approach required tying up large amounts of capital in projects and investments, which necessitated significant leverage, higher risk, and relatively low margins. Although that is still a major part of Brookfield today, the most important and fastest-growing feature of the business is its asset management model.
Drawing comparison to the quote from Warren Buffett above, the asset manager business is fine tuned for high returns and durable growth over a long time period. But it goes one step further. Instead of deploying its own capital, Brookfield sources investment funds from institutional clients. This means that after deducting manager compensation and other direct costs, Brookfield earns an almost infinite return from its asset management business as it requires minimal internal capital.
And the segment scales remarkably well. After building out the asset management business, Brookfield has seen fee revenue rise three-fold since 2012, while margins have expanded from 41% in 2012 to 66% in 2017, leading to five-fold increase in fee related earnings to $896 million, as illustrated in the table below.
And while the results above look promising, they obscure the true picture. That’s because, in addition to its base management fees and incentive distributions which comprise the majority of its fee revenue, Brookfield earns carried interest on all of its carry eligible capital if it meets a predetermined target return in its funds. Carried interest is accrued over the life of each fund, but due to the conservative nature of accounting standards is not recognized in the financial statements until funds are wound down.
Adding in this hidden, unrecognized profit, management estimates that true economic income of its asset management business is not the $896 million from the table above, but rather $1.82 billion in 2017 when factoring in the unrealized carried interest, and $1.67 billion annualized for 2018.
Sustainability And Market Opportunity
Brookfield earns carried interest as an incentive for reaching a target return (i.e. the preferred return) on funds its clients invest in. Although the preferred return may vary, management offers 8% as an example of the typical target. In the graph below (slide 85/118 of linked presentation), the company presents its average gross returns (before fund expenses, management fees, and carried interest). The Gross IRR column shows that the company is earning a low of 13% in its credit and core plus funds up to 23%-28% in its opportunistic funds. Each fund type clears the 8% preferred return rate by a healthy margin, even after subtracting out approximately 2% for a base management fee.
When a fund achieves its preferred return, the profits get divided up as follows (based on example provided by Brookfield: slide 84/119 of linked presentation):
What’s clear is that Brookfield profits handsomely from its carry eligible capital by collecting up to 5.6% of a 20% total profit as in the example above. Provided that they can sustain this level of performance in the future, Brookfield can achieve exceptional returns on its fee bearing and carry eligible capital.
Meanwhile, Brookfield will benefit from an expanding market, both in total capital available and the amount dedicated to the alternative assets where Brookfield specializes. Management forecasts growth of institutional capital from $52 trillion in 2017 to $100 trillion by 2030.
(Source: Slide 12/119 of linked presentation)
And allocations of these funds to Brookfield’s real and alternative asset niche is estimated to increase from 25% in 2017 to 40% or more by 2030.
(Source: Slide 17/119 of linked presentation)
Applying simple arithmetic, this puts total allocations at $13 trillion (25% x $52 trillion) in 2017, then growing to $40 trillion by 2030. The result is a 9% cumulative annual growth rate. But with a superior reputation, long-term track record, and scale advantages, Brookfield has potential to capture a growing market share and exceed the industrywide 9% estimated annual growth rate.
Putting it all together, a scalable business model with superior returns, growing pools of institutional capital, and potential for greater carried interests mean that it’s harvest season for Brookfield’s asset management business.
Valuation And Potential Future Returns For Brookfield
The asset management segment is a strong business but only makes up part of the company. At its recent investor day (slide 68/119 of linked presentation), Brookfield demonstrated how it values the company, separating out its asset management business and invested capital.
Although some may use different methods, assuming management’s model is accurate, asset management now makes up 45% of the business and grew at a 17.7% rate, while invested capital was 55% with a more modest 5.8% growth rate in 2017.
Using this same approach and modeling constant cumulative annual growth rates of 17.7% and 5.8%, Brookfield’s compounding potential through 2023 could reach 129% from its current $43 billion market cap.
Management’s valuation assumes a 24% discount to market value (~31% return if discount is closed), which seems aggressive. My 129% estimate also assumes the closing of this discount. To arrive at a more conservative estimate, I add an additional measure at the very bottom of the chart showing the return if the discount doesn’t close, which reaches 74% by 2023, or approximately 11.8% CAGR.
Regardless of the ultimate accuracy of the model, a key item that can be gleaned from the chart is that, extrapolating current growth rates, the value of the asset management business will gradually become a larger part of the value of the company. Using the highly simplified model, this would lead to accelerating annual returns, rising from 10.8% in 2018 to a predicted 13.3% by 2026. Brookfield’s 1.4% dividend yield will bolster shareholder returns.
The model makes many assumptions, many of which will not square with reality as time reveals the actual results, but it gives some perspective by providing a general idea of potential future returns and what needs to happen in order for them to be realized. For what it’s worth, Brookfield’s own model forecasts 24% annual returns through 2023.
(Source: Slide 108/119 of linked presentation)
A few considerations come to mind when evaluating some of the underlying assumptions of this chart in context of what we’ve learned thus far. This, again, assumes a closing of the current valuation gap giving a 31% one-time boost in return. It also assumes that the market values Brookfield at multiples which clearly depart from current and historical measures. If relying on this model, one must assume that BAM will be valued at a higher multiple in five years than it now is even after a historically long bull run. That is theoretically possible if Brookfield can deliver sustained high growth, build the asset manager into a larger portion of its business, and still demonstrate that it has a large future runway after another five years. But investors should keep in mind that the aggressiveness of these assumptions has some downside risks.
Of course, great businesses have a tendency to surprise to the upside, and there’s little in Brookfield’s track record and past performance that would indicate that they can’t meet their own goals. All that’s left to find out is whether they can repeat strong past performance under the operating environment they’re given today and in the future.
I like Brookfield and own it as one of the largest positions in my Prime Portfolio. I expect to use current cash holdings to add my fourth tranche of Brookfield stock over the coming week. Prior to adding to Brookfield, the Prime and Action Portfolios look like this in early October 2018:
Disclosure: Jason Rowland owns shares of Brookfield Asset Management (BAM) and all stocks in both The Prime Portfolio and The Action Portfolio.
Disclaimer: I am not a registered investment advisor. I receive no compensation from any of the companies of which I own shares and of which I write about. The strategies discussed are designed to suit my own investment objectives, not those of any other individual. They are for illustrative and educational purposes, and they are not guaranteed to be effective. It is possible that not all material information will be discussed about each security highlighted on the site.
All investments involve risks. All information on The Virtuous Cycle website is general analysis and my own interpretations of available information. It is neither financial nor investment advice, nor is it a recommendation to buy or sell any security based on an individual's specific investment goals or financial situation. Individuals must do their own due diligence and determine how each investment fits into their own investment and financial plans prior to making their own investment decisions.