Business Breakdowns
· Hunter Hopcroft
[00:00:00] S1: In fact, in 2022, Financial Times runs a headline, "Apollo Athene: The New Berkshire Hathaway." The headline ends with a question mark. I think we've seen many times where this type of headline can be a curse, but Athene is really a different animal. This was another opportunistic trade for Apollo that turned into a full-fledged business. A lot of Apollo's success seems to come from them getting into a jam and then figuring out a very creative, financially engineered way to get out of it. I think Athene is really no different. Athene begins its life as an Iowa-based insurer called American Equity Life. Here I think we have to do a quick insurance industry primer. Another very complex industry. It has a historical role in the alternatives space, and it helps illustrate why Apollo's approach was so bold. Insurance—everyone's basically familiar with the business model. People pay premiums, the insurer invests those premiums, and those investments help support liabilities that come from the insurance product being sold. There is a spectrum of insurance liabilities from somewhat simple to complex. Complex would be things that are very actuarially difficult to underwrite—things like crop insurance or even some property and casualty. Simple liabilities are more actuarially certain. Something like an annuity where you're promising a stream of payments in the future, or even life insurance where they have a pretty good actuarial idea of what their life insurance liabilities are going to be. Post-GFC, this creates issues because especially in the annuity business, annuities were struck at higher rates. So someone might be promised a payout of 4, 5, or 6%. Post-GFC, yields come way down and insurers face a giant mismatch—they're no longer making spread because they owe people a certain rate, but they can only reinvest at lower yields. Additionally, their bond portfolios are way down and the new assets are not yielding enough to create that spread. So insurers start unloading insurance assets—which really are insurance liabilities—to alternative managers. Alt managers, in this desire to get off the vintage fund treadmill, are attracted to this long-duration capital that, for them, is at reasonably low cost. Insurance is highly regulated, and basically 90 to 95% of that capital must be invested in investment-grade fixed income, AAA, or cash.
· Hunter Hopcroft
5 to 10% of that becomes equity that you can take more risk with. That's really what these alt managers are attracted to. They can maybe earn a little bit of spread on that 90–95% portion, but that 5 to 10% is a great source of long-term, low-cost capital—capital that allows them to grow their businesses and seed other strategies or funds. All alt managers post-GFC make varying degrees of investment into the insurance business. Some are joint ventures, some are equity, some are just management agreements. But they're all playing in this space a little bit. Apollo buys American Equity Life in 2009, and it's such a great opportunity because they load the balance sheet with mortgage-backed securities, the prices of which have collapsed, but they're still paying out nonetheless. By 2010, the fixed income markets normalized and now Apollo's biggest client is this insurance company that needs to make money from spread—not risky LBOs and buyouts. Athene goes public in 2016 and Apollo owns 35% of it. This is where I talk about Apollo getting into a jam. The stock is struggling because it's seen as just this fee pick for Apollo. It's paying out tons of fees to Apollo to manage its assets. But at the same time, Athene is 30% at this point of Apollo's asset base. So they can't lose the account. Rowan realizes they have to merge. This is really risky. This is what the next Berkshire Hathaway question mark speaks to. Insurance is a highly regulated, capital-intensive business that typically trades at a much lower multiple than alternative managers do. There's actually a great quote from an unnamed Apollo executive. He goes, "I get why this is good for them, but I'm not totally clear on why this is good for Apollo." As a private equity firm, Apollo earned enormous fees by tying up little capital of its own. Now the firm will be in this capital-intensive insurance company, overseen by regulators watching for risk, given its hundreds of billions of dollars of assets.
· Matt Reustle
[00:00:00] S0: Yeah, it's interesting to hear that previous relationship where you had two publicly traded companies with a lot of interaction. It's like the real-world version of a circular reference that you get in your model when you're trying to adjust for the different dynamics there. One thing I just wanted to zero in on, in terms of that initial move where insurance portfolios have liabilities that you need to invest to offset, is that 90% is going to be investment-grade. That other 10% has a little bit more flexibility. Would you say with alt managers that it's essentially that 10% portion of the portfolio that really makes the difference in their ability to manage those assets and liabilities, or could it be both? But in terms of where the difference is made—between Apollo managing that versus it being on the insurance balance sheet—is there anything in that 90% where they can make a difference?
· Hunter Hopcroft
[00:00:00] S1: This is really where Rowan has his big breakthrough in the genius of what he decides to do. You're right, that 90–95% for most alt managers or insurance companies is basically a commodity, investment-grade asset. Fixed income management is basically a commodity. You can earn spread on that with a little bit of creativity. Rowan realizes that he needs to be in the spread-generation business. His big breakthrough is using the equity—the bottom 5 to 10%—to acquire or otherwise seed asset origination platforms. These are people that are going to be basically mini banks—not banks, but people that are originating de novo debt, what we might think of as private credit or asset-backed debt. This is a big differentiator for Apollo because for most of the other alternative managers they are in the flow buying business. They have to buy what comes out of investment banks or what comes out of the broadly syndicated loan market. They are used by other alternative managers to realize spreads of 90 to 95%. All they can buy is what's for sale on the market. Rowan realizes that he needs to be in the asset origination business. And so he uses this 5–10% of equity that's at the bottom of the insurance capital stack and he starts building, acquiring and seeding asset origination platforms. There are many components here. There's a company, MidCap, which has a publicly traded BDC that specializes in lending to mid-sized businesses and mostly healthcare companies. There's Merx Aviation in Ireland that provides financing for aircraft leases. All of these generate fixed income assets that can feasibly be fed back into the top of the balance sheet to generate additional equity. But what's really genius is using this private equity structure. He's seeding these platforms, but he's raising outside capital for them as well. And all of these origination platforms are essentially obtaining private equity economics—with fees and carry—while feeding the insurance business on the other side.
· Matt Reustle, Hunter Hopcroft
[00:00:00] S0: Yeah, it's really interesting to think through. It might just have to do with market dynamics. But is there any reason why they wouldn't just be in-house? You might be able to explain where the fee structure and that type of relationship is more beneficial than just housing it on the balance sheet. But is there anything that immediately stands out as to why the relationship is better in that form than being in-house? [00:00:00] S1: Right, so let's say it was all in-house. You would have your 90% of investment grade, and you'd have your 10% that dropped down. So basically, for every hundred dollars of insurance assets you bought, you would get $10 of equity to do your alternative manager strategies, to do LBOs or private credit—whatever you were doing. But what Rowan has decided is he's going to take that $10 and have these platforms use it; he's going to use $5 to put into an origination platform and raise another $5 of outside capital. And now that $5 is receiving GP economics—or a sort of private equity structure—on the returns and carry from that originator. And whereas something housed entirely on the balance sheet, you buy $100 of insurance assets, you get $10 of equity. Rowan has figured out a way to buy $100 of insurance assets and turn it into more like $30 of equity by running it through this private equity structure. They get fees and carry on the origination platforms that he's seeding. [00:00:00] S0: Yes, I think we have arrived again at the theme of complexity and finding creative ways to generate returns.
· Matt Reustle, Hunter Hopcroft
[00:00:00] S0: Yes, I think we have arrived again at the theme of complexity and finding creative ways to generate returns. [00:00:00] S1: That's really the tip of the iceberg, because there's a whole other level of financial engineering that's going into these balance sheets too. If we think of the traditional private equity structure, LP Capital is really a form of leverage. In some sense, it's equity, but it's leverage for the GP in that they're participating disproportionately in the upside over certain hurdles. And through very complicated structures, Rowan is taking this $10 of equity that's dropping out of insurance assets he's buying and using it as their GP stake on all of these other origination platforms that can generate private equity–like returns. [00:00:00] S0: Yep, that makes sense. And I guess just on that point you mentioned, it is essentially a form of leverage in many ways. It's a form of liability in the sense that when a fund is retired, when it reaches the end, that capital theoretically goes back to the investors. And Apollo keeps some percentage based on the return profile and the fees that they earned.