Brookfield Asset Management (BAM) Investment Thesis, Part II

In Brookfield Asset Management (BAM) Investment Thesis Part I, five sources of value creation were discussed. Four of these sources have been in place for years. The fifth source, transforming to an asset manager, is the anticipated catalyst going forward. The transformation will help the market better recognize the outstanding performance and understand the value proposition. BAM’s performance has so far been largely ignored even though it rival’s Berkshire Hathaway’s performance.

BAM has completed its’ transformation into a global alternative asset manager with $181 billion in assets under management (AUM). They have over a 100-year history of owning and operating assets with a focus on renewable power, property, infrastructure and private equity.

BAM II Series Collage

The business model is straight forward. The key elements are to: identify and acquire high quality real assets at favorable valuations, below replacement costs, finance them on a long-term, low-risk basis, and enhance the cash flows. The cash flow improvements increase the value of the assets while they earn reliable, attractive long term risk adjusted total returns for the benefit of shareholders. Perhaps straight forward but hard to replicate; the discipline and patience needed to adhere to these key elements are core to the culture and built over decades.

This Part II of the BAM Investment Thesis should be read with Part I [Source] and also the posts on the major business platforms to gain a full appreciation of the opportunity. In this concluding summary BAM’s intrinsic value as an asset manager is determined using straight forward assumptions that implicitly assume a decline in performance although no expected.

Brookfield Asset Management Valuation Summary:

The beauty and significance of BAM’s transformation to an asset manager is the continued use of a proven and successful business model focused on real assets. Their success, although at times ignored by Mr. Market, is recognized by institutional investors willing to pay BAM to manage their capital for similar results. This performance and transformation creates new leverage for shareholders as the company continues to realize these results on its own invested capital and earn fees for producing the same results for other investors.

Please be advised this valuation needs to be updated to reflect the completed transition of BAM to an asset manager. A link to the updated valuation will be provided here for viewing when it is complete.

 

Approach:

The increasing fee bearing capital, entrusted to BAM as an asset manager, results in a stream of fees with a high rate of growth incrementally adding to the outsized returns already realized. To quantify this impact we follow BAM’s ten year plan and analysis as presented by Brian Lawson, Chief Financial Officer, during Brookfield Asset Management 2012 Investor Day presentations [Source]. The presentation was sound and easy to follow so the approach is used here, however, the assumptions were varied when appropriate to reflect an independent point of view.

The business plan was presented as “anchored by a relatively small number of very straight forward assumptions and some very simple linear relationships.”  They are:

  1. The capital in the listed entities (BIP, BREP, and BPY) increases in line with their respective target distribution growth and the issuance of equity to fund the growth.
  2. BAM achieves the target fundraising goals for private funds with current market fees.
  3. The capital invested achieves target returns.
  4. There is no major reallocation of invested capital.

Not coincidentally, these are the assumptions used in the valuations of Brookfield’s infrastructure, renewable energy, property and private equity and fund platforms. It is important to recognize that the past performance of the business platforms, in every case, exceed the target goals. Management is not asking us to believe their future performance will outshine the past but will be a continuation of a proven track record. Past performance doesn’t guaranty the future but it is encouraging.

Asset Management Fees:

First some definitions:

Capital under management: is the capital committed, pledged or invested in private funds, listed entities (BIP, BREP and BPY) and includes both called and uncalled amounts.  It also includes the capital committed by BAM or entities managed by BAM and is the basis for determining base management fees in the private funds or listed entities.

Fee bearing capital: represents capital under management that is managed by BAM under contractual arrangements to earn asset management revenues.

Un-invested capital: (dry powder) is capital that has been pledged to invest on behalf of a client; BAM typically earn base management fees from the time of the commitment until the capital is invested.

Asset management revenue includes base management fees, incentive distributions, transaction and advisory fees and performance income.

  • Base management fees are earned by contractual arrangements and typically equal to a percentage of the capital under management and are accrued quarterly.
  • Base fees are earned on capital under management from both clients and Brookfield’s direct investments alongside the clients.
  • Incentive distributions are a percentage of distributions paid by the managed listed entities (BIP, BREP and BPY) above a predetermined threshold. It is as an incentive for BAM, the general partner, to increase distributions to unit holders, the limited partners.
  • Performance income includes “carried interests” where BAM receives a fixed percentage of investment gains above a predetermined minimum return to the private equity investors. Carried interests are paid near the end of the life of the fund after capital has been returned to investors.
  • Carried interest may be subject to forfeiture or “claw back” provisions until all investments are monetized and the minimum investment returns to investors are sufficiently assured.

Growth in Fee Bearing Capital:

Listed Funds:

“Listed funds or listed entities” are the three major publicly traded limited partnerships or business platforms: Brookfield Infrastructure Partners (BIP); Brookfield Renewable Power (BREP); Brookfield Property Partners (BPY). Brookfield Asset Management as the general partner of these entities collects management fees for managing the assets on behalf of the unit holders who invest capital in them. Investors’ capital in these partnerships is a source of fees “fee bearing” to BAM as the general partner. As the capital grows so do the fees.

The five and ten year outlook (valuation) for each listed entity was estimated in earlier posts and within the framework of the business plan presented in the 2012 Investor Day Presentation. The assumptions are based on the entity’s target total return, target distribution growth rate, return on reinvested capital and equity issuance to fund growth.

The underlying premises for Case I “Low Case” is achieving the lower end of the targeted total return or 12%/year per unit. Case II, the “Moderate Case” is achieving the upper end of the targeted total return or 15%/year per unit total return. We take comfort in that the three business platforms have established an enviable record of exceeding the upper return target over time.

The specific assumptions used for each entity are detailed in the tables below and discussed in their respective posts for BIP [Source]; BREP [Source]; and BPY [Source]:

BAM II Key Assumptios

Applying these assumptions to the listed funds, the market capitalization increase with the target growth in cash flows, distributions and equity issuance over the 10 year period from about $25 billion at year end 2012 to $74 billion and $82 billion in the Low and Moderate Cases respectively:

BAM II Market Capitalization

The Listed Fund Fees:

Base fees are earned on capital from both clients’ and BAM’s investments in the entities. The base fees paid by BREP are $20 million per year and an additional marketing services fee of $18 million per year for a total of $38 million per year. BPY pays a base fee of $50 million per year. These fees are subject to certain escalation provisions and for the purposes of this analysis we assume they escalate at the rate of inflation. BIP does not pay a set base fee of this nature.

The growth in listed funds increases the asset management fees paid by the listed entities to Brookfield Asset Management. BAM earns an “equity enhancement” fee where they receive 1.25% of the equity market value and net recourse debt of each entity over a threshold set at the time of the spinoff. The threshold is about $8 billion for BREP and $11.8 billion for BPY. BIP does not have an equity enhancement threshold and pays the 1.25% on the full equity market value but does not pay a set base fee.

Incentive distributions are performance fees where BAM can earn a percentage of distributions paid by the managed listed entities (BIP, BREP, and BPY) to unit holders above a predetermined threshold. The threshold for the incentive distributions or “incentive distribution rights” (IDR’s) vary by entity. The agreements between the entities and BAM are summarized in the table below and used to determine the asset management revenue paid to BAM through the 10 year period.

BAM II Fees Summary

The base fees of listed funds (BIP, BREP, and BPY) are not impacted by the total return and increase at the assumed rate of inflation:

BAM II Base Fees

The increases in market capitalization of listed funds (BIP, BREP, and BPY) also result in increases in the equity enhancement fees over the 10 year period. They increase significantly from about $86 million at year end 2012 to $628 million and $710 million in the low and moderate cases respectively:

BAM II Equity Enhancement Fees

Through incentive distribution rights (IDRs) BAM receives an incentive to increase the distributions per unit of the listed funds (BIP, BREP, and BPY) above a predetermined threshold. This growth in distribution payments aligns the interests of the general partner (BAM) and limited partners (unit holders) who are often income oriented investors by also benefiting BAM when the increases occur. This is in addition to BAM’s direct distribution payments through their direct ownership of limited partner units as well. The following incentive distribution fees occur as the target increases are achieved. The incentive distributions grow from about $23 million at year end 2012 to $195 million and $367 million in the Low and Moderate cases respectively:

BAM II IDR Fees

Private Funds:

“Private Funds” are formed for institutional investors to invest alongside Brookfield Asset Management’s own capital and the listed entities (BIP, BREP, and BPY). The weighted average commitment term for the funds is about 9 years. As of 1Q13 there are 29 private funds under management and 7 new funds in the process of raising capital.

Management’s goal is to raise $5 billion during 2013 and 2014 and during the Investor Day Presentation discussed private funds increasing at the rate of 11% per year over the 10 year period.  The 11% per year rate seems reasonable considering they raised about 19% per year in the past two years. This averages about $3.5 billion per year through 2017 then increasing to an average of about $5.5 billion per year 2018-2022.

Brookfield’s strong return performance and the rising popularity of alternative real assets have created considerable momentum in raising private funds. Assuming they are successful raising the $5 billion followed by an 11% per year increase through the period, $65 billion will be raised by 2022 exceeding BAM’s internal target of $50 billion.

BAM II Private Funds Raised r1

The historic mix of private funds (core, value-add or opportunity) resulted in a weighted average gross return of 20% per year through the funds life as of December 2012. In the Low Case a 15% per year return is assumed and in the Moderate Case the historic 20% per year return is assumed. The Low Case represents the potential for lower investment returns as funds increase and the available opportunities potentially decline. An offsetting factor is BAM’s history of returning un-invested funds to investors rather than lower the return standards. The charts below show private fund growth through fund raising and return for the two cases:

BAM II Private Funds and Returns

Growth in Private Fund Fees:

The base fees earned on the private funds depend on the mix; core, value-add or opportunity. Management estimates these trending to a weighted average of 1.35% by 2017 and 1.50% by 2022. The base fees increase significantly as private funds are raised:

BAM II Private Funds Fees

Brookfield earns a performance fee or profit interest on private funds referred to as “carried interest” ranging from 10% to 20% of the returns realized depending on the type of fund. Carried interest is earned after a minimum threshold return or “hurdle rate” is achieved. The carried interests are paid out near the end of the funds life after capital has been returned to investors and are no longer subject to future events. Based on the historic mix of funds; the weighted average hurdle rate is 10%/year and the carried interest is 19% respectfully. Applying these to the private funds yield the following performance payments for the Low and Moderate Cases:

BAM II Carried Interest

Funds from Operations:

Tying these together shows that Brookfield Asset Management’s General Partner activities potentially triple FFO to about $1.5 billion annually in the Low Case and to more than $2.0 billion in the Moderate Case:

BAM II FFOs

Our estimates bracket the estimates provided by management during the Investor Day Presentation with the largest variance occurring in the private fund results:

BAM II Investor Day FFO

Valuation of General Partner Activities:

The general partner valuation multiples are: annual carried interest at a multiple of 10X and a 70% gross margin; base fees and incentive distribution rights at a multiple of 20X and a 50% gross margin; the net accrued carry multiple at 1X,

The increase in FFO has the potential to increase the value of the General Partner’s activities 5 fold in the Low Case to over 7 fold in the Moderate Case from about $6 billion to $28 billion and $43 billion respectively.

BAM II General Partner Value

BAM’s Invested Capital:

Brookfield Asset Management has significant capital invested alongside of their private equity clients and limited partners (unit holders in the listed entities). BAM invested capital includes the direct investments in the listed entities, the investments alongside institutional investors in the private funds and direct investments in listed companies that are not fee bearing.

The direct investments are in a broad range of industries and overseen by the private equity group.  The portfolio contains a number of investments impacted by the North American home building industry. They include interests in Norbord Inc., a panel board manufacturer, and two publicly listed residential development businesses: a North American homebuilder and land developer, Brookfield Residential Properties Inc. and a Brazilian condominium developer, Brookfield Incorporações S.A. The operations in this segment tend to be more opportunistic in nature and the businesses are not integrated into core operating platforms.

Brookfield Asset Management’s capital invested alongside institutional clients and limited partners enjoy the identical return prospects by definition showing significant growth from about $23 billion to $80 billion and $96 billion in the Low and Moderate Case respectively:

BAM II Invested Capital

Intrinsic Value:

Not surprisingly, the underlying asset base is growing with BAM’s strong returns in the underlying businesses, the general partner fees are increasing with strong returns and performance incentives. We can anticipate the potential for the Low Case valuation to double in perhaps five years and triple in ten years. In the Moderate Case there is the potential for more than a fourfold increase in the ten year case:

BAM II Valuation

Please be advised this valuation needs to be updated to reflect the completed transition of BAM to an asset manager. A link to the updated valuation will be provided here for viewing when it is complete.

 

Risks:

As with any equity investment there are various risks to consider including the following four key risks:

Political Risk: Some of BAM’s investments are in emerging economies where socio-economic factors can result in politics that, at times, adversely influence the business environment.

An offsetting factor is Brookfield’s global perspective and years of operations experience in the emerging economies where they operate. Management uses their global presence defensively so if political risks become uncertain they focus on more stable environments. For example, property and infrastructure assets in Australia, enables BPY and BIP to benefit from rapidly growing economies in Asia.  BPY and BIP assets are located in politically stable Australia that provides resources for Asia without the direct investment in potentially higher risk countries.

Competitive Risk:

Real assets are growing in demand by investors driven by macroeconomic factors; high volatility in the financial markets; concern with high rates of inflation; and low return in other asset classes. This attracts new competitors into real assets and alternative investments, BAM’s historic area of focus. When competition increases the historic returns realized by BAM may become more difficult to achieve as opportunities are chased by more competitors.

For example, Bloomberg reported today [Source] that Morgan Stanley’s infrastructure investment unit plans to seek $4 billion for a second global fund…Morgan Stanley, the biggest financial brokerage, is among a number of firms targeting billions of dollars globally for investments related to public works. Toronto-based Brookfield Asset Management Inc. (BAM/A) is seeking $5 billion for a private infrastructure fund, according to a March agenda from New Mexico State Investment Council. As of the end of the first quarter, 144 unlisted infrastructure funds were trying to gather $93 billion in capital, according to data from London-based research firm Preqin Ltd.

An offsetting consideration is BAM’s long history in real asset investment and global presence providing access to both opportunities and capital looking for experienced and proven performance management. BAM’s strategy differentiating itself as specialists in real assets is a tremendous competitive advantage as others scramble to acquire or develop expertise and demonstrate capability. Further the total amount of investable real assets is estimated by BAM to by $45 trillion in 2012 and growing to $70 trillion in the 2020s; it is a huge market with a long way to go.

Performance Risk:

The returns and resultant valuations are dependent on a high level of management performance producing total returns in excess of 12%. There is no guaranty that the management team can continue at this performance level.

A comforting and mitigating factor is the performance level used in this analysis is management’s excellent track record over a long period of time. These are not Herculean assumptions hoped for from an unknown management team. That’s not to say it will be without challenges but the track record is encouraging since this performance has been demonstrated through prudent capital allocation, critical thinking and a refreshing ability to walk away where risk is unacceptably high or returns too low.

Interest Rate Risk: The listed entities managed by BAM (BIP, BREP, and BPY) will likely be viewed as income investments. Income investments can trade somewhat like bonds, rising when interest rates fall and vice versa. We are likely facing higher interest rates in the future. They also use debt to finance the business so a rise in interest rates will, all else equal, decreases returns.

Offsetting the interest rate risk to some extent is BAM’s current strategy of refinancing debt at the low interest rates present today and lengthening terms. Also, increasing interest rates tend to occur in improving economic environments where capacity utilization of infrastructure, commercial property and energy assets tends to increase and improve cash flows.

Summary:

In the Brookfield Asset Management (BAM) Investment Thesis, Part I [Source] we outlined five sources of value creation for shareholders. Four of the sources; operations, capital allocation, asset appreciation and outstanding management have been in place for years. However, for whatever reason the market has largely ignored their outstanding performance that rival’s Berkshire Hathaway.

BAM II Investment Performance

The fifth source of value creation is the transformation to an asset management company and the associated restructuring. This catalyst will in time facilitate analysts and investors understanding of the business platforms and appreciate the performance that characterize Brookfield. The ability to choose any combination of: infrastructure, renewable energy power, property, private equity, or asset management and invest accordingly on a very attractive risk/reward basis will likely bring the long overdue recognition of Mr. Market.

Income and growth investors can enjoy the attractive distribution yields and growth offered by Brookfield’s listed entities; Infrastructure (BIP), Renewable Energy (BREP), and Property (BPY) and the exceptional risk adjusted total returns.

Investor’s interested in capital appreciation can invest in Brookfield Asset Management (BAM) with  outstanding risk adjusted total returns of the underlying listed entities and strong growth through increasing asset management revenues. Diversification is achieved geographically and across asset classes: infrastructure (rail, ports, distribution); utilities (renewable hydroelectric and wind); property (class A commercial office and retail); private equity; and asset management while participating in investment opportunities and returns available to some of the worlds most sophisticated institutional investors.

Are these return estimates too high to be realistic? Perhaps, but the underlying assumptions used to generate these results are straight forward:

  1. Listed fund capital increases with target distribution growth and issuance of equity to fund the growth;
  2. Target fundraising goals for private funds are achieved with current fee structure;
  3. Target returns are achieved in capital invested;
  4. There is no major reallocation of invested capital;

Then considering; the analysis is centered on BAM’s historic capability; built on BAM’s own performance goals (remember these guys are prudent); and at a rate that Brookfield has exceeded in the past brings.

I have owned shares in BAM and the listed entities for years in a combination the suits my preferred income and growth mix and recently purchased additional BAM shares and BPY units. Over that time, like all investments, I followed closely reading releases, filings, and listening to conference calls. Each year they gain additional respect for; the capability, openness and honesty of management; their long term shareholder focus; and their hard work and outstanding performance on our behalf.

Too high-I don’t think so, but you have to decide for yourself. There are no guarantees in life but if this management team continues to do what they’ve demonstrated it becomes “just arithmetic” for us shareholders. We are not hoping for a change, just the opposite, we are hoping management keeps on keeping on.

Not in any way to diminish the hard work or the challenges and competition they face every day; with the demonstrated performance below we hope “only” to get 12-15%. I’m in.

BAM II Funds Return

Disclosures: Long BAM, BIP, BEP, BPY, BRK

References:

  • Brookfield Asset Management Website [Source]
  • Brookfield Asset Management 2012 Investor Day presentations [Source]
  • Brookfield Asset Management (BAM) Investment Thesis, Part I [Source]
  • Brookfield Infrastructure Partners (BIP) [Source]
  • Brookfield Renewable Power Partners (BREP) [Source]
  • Brookfield Property Partners (BPY) [Source]
  • Brookfield Capital Partners (BCP) and Private Funds [Source]

 

Comments

  1. Could you explain what the “non fee bearing” AUM relate to? Approx $175bn minus $78bn as in Q2 report.

    Many thanks

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