Morgan Stanley research memo on implied valuation of future performance fees for alternative asset managers

Morgan Stanley | RESEARCH NORTH AMERICA INSIGHT ~~ Deconstructing Our Implied Carry Valuation: What Is the Market Paying? We deconstruct the various pieces of a SOTP for the alts in order to determine our best guess on how much the market is valuing future performance fees. We then divide that implied value by future performance fee earn- ings, to determine the implied multiple that the market is paying for this earings stream. This is the groundwork for our upside and downside scenarios if the alts were to convert to C-corps. We simplify our the SOTP and standardize it across the group to look at &4 main components. 1) after-tax core fee-related earnings, 2) balance sheet value of investments plus net cash/debt, 3) net accrued carry balance, and &) future value of performance fees. The values of the balance sheet and net accrued carry receivable are static items with balances as of 3Q17. We then adjust the multiple on our core FRE to determine a value for what we believe the street is using. To be conservative, we use 15x as a starting point for what we believe is currently priced in. We then take the current share price and subtract out the value of the FRE, net accrued carry performance fees and the balance sheet and we are left with an implied value of what the marketis pricing in for future carry. Once we have the future carry value, we divide by the net performance fee earnings per share for each company and get an implied multiple on the future perform- ance fees. Using this approach and a 15x multiple on FRE, we see the market is valuing future performance fees at 7.5x on average anda We make several key adjustments in the SOTP valuations: First, we use our own Morgan Stanley definition of "core fee-related earn- ings" in our calculation. We use our core approach as we attempt to normalize the various definitions of FRE across the companies. The main difference vs. company-reported FRE is that we fully burden all expenses, including equity-based compensation. KKR differs the most on company-reported vs. MS Core FRE. For more information on our core FRE methodology, please see our note Alternative Asset Managers: Who@Got Swimsuits? (19 May 2016). We also make adjustments for ARES an OAK. For Ares: a signifi- cant portion of the fee related earnings come from Part 1 BDC fees. These are investment income sharing fees from their management agreement with ARCC. In the MS approach, we value these sepa- rately from more traditional management fees. However, we do not believe that the market looks at the fees this way, and so we include them in the total FRE by using the same multiple as we are using for FRE (15x). For presentation purposes in the table below, we break out the BDC Part 1 fees separately for ARES to show the value. OAK: We adjust the balance of OAK@investments on balance sheet to account for OAK© 20% ownership stake in DoubleLine which it currently holds at cost of $21m as adjusted under the equity method of accounting. With the benefit of lower corporate taxes we currently value OAK@ownership stake at $1B. We do not believe the market gives full value for this 20% ownership and haircut our MSe value by median 6.5x. 50% to $500m. We then add this value to the balance of investments and net cash for OAK@total balance sheet value. Exhibit 27: Market Implied Value of Future Carry at current share price and 15x FRE multiple = B+C+D =A-E-F =E+F+G Son | A B (a D E F G H I J | I I I l vena ne After-Tax SOTP _ Pre-Tax Net | vere Total | Pre-Tax Avg. Implied | Ticker Current 2018E FRE Share @ BDC BS Value Value Ex- Carry | Gains of I Value Per [Net Carry Per Future | Price Core FRE Multiple Value Per Per Share Carry Per Receivable | I Share (2018- Carry | 24% tax I Future I Share I ci | Share Share Per Share 2019) Multiple Rate | Carry | I | APO $36.42 669 15.0x $18.94 $0.00 Na $21.66 $2.16 $12.61 $36.42 $2.45 5.1%! ARES $24.70 185 18.4x $12.02 $3.70 $0.69 $16.41 $1.03 I $7.26 l $24.70 I $0.63 11.6x} BX $36.78 1,196 15.0x $11.36 $0.00 $2.83 $14.19 $3.01 I $19.59 | $36.78 I $2.07 9.5x] CG $25.60 100 15.0x $3.34 $0.00 $0.85 $4.19 $4.40 | $17.01 | $25.60 I $2.85 6.0x] KKR $24.40 475 15.0x $6.38 $0.00 $9.71 $16.09 $1.74 | $6.57 | $24.40 | $0.93 7.0x| OAK $45.20 166 15.0x Si2an $0.00 $15.19 $27.30 $5.76 | $12.14 | $45.20 I $2.20 5.5x| —— lAverage 7.5x\ IMedian 6.5x sc — Source: Company Data, Morgan Stanley Research estimates HOUSE_OVERSIGHT_025568