Business Breakdowns
· Sean Barrett, Matt Reustle
And then after that, EQT gets 100% catch-up and they generate a lot of carry all at once. This is different from many of the US players who benefit from American waterfalls, meaning they get carry after each deal is exited and then their investors can claw that back later if the fund ends up performing below the pref. So based on the European waterfall, EQT again is generating very little cash carry right now. But that's an opportunity because we think that they will generate a lot of carry in the next five years. [00:00:00] S0: It's interesting to hear some of the nuance and I know to your point the accounting conventions can be a struggle, but even that higher portion that goes to the deal team, you can make a very strong case that is the best alignment that you can have as a shareholder in terms of what they're being rewarded for. [00:00:00] S1: Totally agree. [00:00:00] S0: When you compare alts against one another, can you compare the financials you mentioned, the percentage that would go to the GP? Is there anything like in the margin profiles of the business that are comps to one another? I'm just curious if there's anything else that stands out. It might just be that GP carry, but given the nature of the operating leverage that exists within these, I'm curious.
· Sean Barrett
[00:00:00] S1: Yeah, I think the biggest nuance or the biggest thing to look out for when studying these alts is the difference in the balance sheet profiles. And EQT is a cap-light business, meaning they have a very small balance sheet. And EQT pays out the majority of its fee-related earnings and carry earnings to shareholders in the form of dividends and stock buybacks. So putting that all together, that equates to something like a 3 to 5% free cash flow yield per annum right now going up probably to 8 to 10% in the next few years. And all of that will come back to shareholders. The other strategy that some of the alts have taken is the balance sheet or capital-heavy investment strategy, which is to grow the balance sheet and compound it as much as they can over time. And I would put KKR and Apollo in that bucket. And then going even further, they've actually acquired captive insurance companies to add other liability streams, if you will, and add other earnings streams to the business. That's a much different profile and a much different bet, if you will. I think the jury is still out on what that means in the near term and long term. Interestingly enough—I mean this is a great debate—but I think it's quite possible that the capital-light models have more stability in the near term because when you have a tough macro or a tough market and public market investors don't know what's on the balance sheet, they tend to ascribe very little value to the balance sheet. That's just the nature of public market investing. With that said, I think there's actually a very good argument to be made that the capital-intensive businesses or the balance-sheet-intensive businesses like KKR have more durability. Because in 30 years, when the market changes and maybe the alts of today are considered the legacy traditional managers of 2050, KKR and others will be able to use their balance sheet to pivot into those new markets and innovate. They all have their own distinct advantages and disadvantages. But the interesting thing about investing in the alt space: you get to pick your poison. You get to pick the flavor that resonates with you.
· Matt Reustle
[00:00:00] S0: And we've alluded to risks. But what really stands out to you for EQT as an investor in terms of risks to the thesis you laid out? Risks to the business? There are the obvious ones, but what really stands out to you?
· Sean Barrett
[00:00:00] S1: There are a few risks here. The first for any alt is its ability to recruit and retain great people and stick to its process. Particularly in Europe, we think EQT has some distinct advantages that allow it to recruit amazing people. It has a long track record of great performance. It has a culture built around transparency and authenticity and the Wallenberg values and people like that. And it pays a really high portion of carry to its deal team at roughly 70% versus many of the other alts that pay people less than that. So that's an advantage for EQT. And with all that said, we track human capital retention and cultural data points constantly to inform our thesis. But that's a big risk with any alt. The second key risk here is macro. EQT is unique in that effectively all its business lines are private equity in nature. So private equity Europe and Asia is obviously traditional private equity. Its infrastructure business in many ways looks like private equity. They aren't buying toll roads; they're buying and building data center businesses. For example, when a good chunk of its real estate business is opportunistic high-return investing. So EQT sold its small credit business a few years ago because they thought it wasn't a great fit for their strengths as active owners. So they don't have a sticky fee-centric credit business like many of their peers. As a result of that, it is a slightly more macro-sensitive business. To exit private equity investments, you don't need an incredible macro environment, but you need a stable macro environment. And the truth is we haven't had a lot of financial stability in the last five years. So it's been a volatile environment that makes it harder for private equity players like EQT to generate carry. And because carry is such a big part of this business, it is actually meaningful for returns. They need to generate carry for us to have a satisfying return, which we would view as 20-plus percent gross return on this investment over many, many years. So that macro piece is important. And with all that said, we think EQT is innovating in ways that will allow it to continue exiting investments and generating great returns for their investors. And then the third risk is a philosophical debate, a philosophical question that has been true, I think, for all the alts for as long as I can remember.
· Sean Barrett
And that is: can they generate high returns with larger and larger fund sizes? EQT's most recent flagship private equity fund was 22 billion euros. The flagship infrastructure fund is about the same size, and that's about double the size of the flagship funds just seven years ago. Can they keep generating 20% net IRRs at this increasing scale? And if they can't, people might not be willing to entrust them with more and more money. So it's really important for the thesis. There are a few ways that we got comfortable with EQT's ability to generate great returns prospectively. One is that their process just hasn't changed. They continue to buy great businesses at fair values and businesses that can grow 12 to 15% per annum, which is really powerful and super unique in the private equity world. Two, their funds historically had a lot of co-invest required to close those deals, which is another way of saying that when they had a 15 or 16 billion euro fund, they were actually probably putting 25 to 30 to work. So they're used to doing this at scale. And three, we think they're local. With local's sourcing model and sector expertise are differentiated, especially in Europe, which has a lot of family businesses. Private equity is really underpenetrated there, and EQT's model is a great fit for that market.
· Matt Reustle
[00:00:00] S0: And I always like to get a sense of the valuation framework that it might apply for a specific business or industry. You seem to be the right person to talk to about this, about equity and alts as a whole. Talk about how you approach valuation from a framework perspective, how that might differentiate from the space, and less so the price target that you might have in mind, but more just around the framework that you would use for valuing one of these businesses.