Today I bought 1000 shares
at $1.25 in Blue Sky Alternative Investments Limited (BLA). Yes, before you
switch your brain off at the mention of such a speculative sounding name (at
least I initially did), please let me explain myself. And no, this has nothing
to do with renewable energy.
Blue Sky is essentially in
the funds management business, perhaps one of the most profitable business
models known to man. It works like this: investors hand over their money to
Blue Sky who go and invest it in areas they believe will do well. As remuneration
for this work, Blue Sky takes a slice of the invested assets each year - known
in finance speak as assets under management (AUM) - and is also rewarded
through performance fees if they surpass a certain benchmark for investors. Less important forms of revenue include transaction costs and other fees.
Typically, fund managers or
more specifically hedge funds operate on a '2 and 20' basis, taking 2% of AUM
each year and 20% of any outperformance. As you can see, even if they produce
mediocre results and aren't awarded any performance fee, they still get to take
2% of investors' assets each year. With $250 million currently under
management, Blue Sky typically takes in 1.5%-2% per year, equating to $3.75-$5
million for not a whole lot of work. Performance fees and other costs are just
the icing on top.
The beauty of this system
is that when AUM increases, management and performance fees largely drop
straight to the bottom line, since as a proportion of revenue growth, increases
in costs are relatively small. Sure, you may have to hire a few more people to
invest money and handle the paperwork, but when you're dealing with hundreds of millions of extra AUM, costs become less important. In their own words: BSAIL expects to be able to significantly grow AUM and management fee revenue without adding significant staff or employee related expense. Unfortunately, this potential for large increases in profits also works to the downside if AUM decreases. Another positive trait is that since these businesses don't require much capital expenditure, the majority of earnings can be paid out as a
dividend without restricting AUM growth.
Thus the key to making a
fortune in this business is being able to attract more money and grow AUM. One
of the most important influences on this is the investment performance. Making
money on your assets increases the amount of assets you have, just like any
regular investor. Good results also strengthen confidence in the ability of the
investment managers and this is certain to pull in more funds, both from
existing investors and new ones. On this score, Blue Sky is looking very good
within each of its four 'alternative' asset classes, producing a 15.6% annual
return net of fees from July 2006 to February 2013, compared to
5.0% for the ASX 200 accumulation index. While this is of course no guarantee
of future performance, around 6 and a half years of strong performance indicate
Blue Sky not being run by incompetent investment managers. Some other factors affecting AUM
include the effectiveness of marketing efforts, which Blue Sky is spending big
on as of their most recent half yearly report; and the general investment
climate, which is largely out of their hands.
Speaking of their asset classes, I'd better
briefly explain what they are. Blue Sky have their hands in:
• Private equity - focused on funding rapidly
growing businesses with equity, not debt, and also differs from venture capital
in that these are profitable enterprises, not start ups.
• Private real estate - involved in
developing and managing affordable residential real estate.
• A global macro hedge fund - able to go long
and short on equities, fixed income, currencies and commodities.
• Water entitlements - essentially buying rights
to a water resource, such as a river, from State Governments and then selling a
specific volume of water to other users.
I'm not qualified to assess the quality of each
and every one of their investments, but again, each of these alternative asset
classes have beaten their respective benchmarks by a significant margin since
inception. Performance speaks for itself.
However, I can take a stab
at predicting the size of the alternative investments industry, which evidence
suggests will grow dramatically in Australia. Blue Sky notes that we are 10
years behind the US and Europe in portfolio allocations to alternative
investments. Signs of Australia starting to catch up include the Australian
Government's Future Fund increasing its allocation to alternative investments
from 10.9% in June 2010 to 34.3% in 2011. Further growth worldwide is predicted
by McKinsey, who have conducted a 'comprehensive multiyear global research
effort', which you can read here.
Blue Sky is well positioned to capitalise on this trend as the only listed
alternative investment business on the ASX.
Even if alternatives don't
end up growing massively in Australia as overseas, the funds management
industry should provide a nice macro tailwind for Blue Sky. Over the past 10
years, total funds under management in the industry has grown at a rate of
12.9% pa to a whopping $2.1 trillion as of March 2013. Furthermore, the
mandatory increase in superannuation contributions from 9% to 12% over the
coming years will provide an extra boost to an already fast growing sector.
Taking all of this into
account, management are aiming to increase their AUM from $250 million to $500
million in 12 months, and have a 4 year target of $2 billion. This seems quite
ambitious but if they can pull it off, there is certainly blue sky potential
for investors. I would take these forecasts with a grain of salt - in their
November 2011 prospectus Blue Sky had AUM of $180 million which was predicted
to increase to $298 million by 30 June 2012, however the final result ended up
being just under $200 million. That's a large discrepancy that needs to be
taken into account when assessing the quality of management, but perhaps
achieving their FY2012 profit of $3.5 million is somewhat redemptive, and
after all, the majority of prospectus forecasts are on the optimistic side in
order to attract investors. I'd suggest management focus on attracting money
from a different kind of investor if they want to produce results. Hopefully
they've learned from this disappointing AUM result and their current forecasts
are more realistic. Time will tell...
Having said that, I am of
the belief that management will do well and that they have confidence in their future
prospects. Flicking through the credentials of the 15 investment
professionals, they look quite impressive (and relevant) with multiple executives attending
Harvard Business School for the Private Equity and Venture Capital course, and coming from top management consulting firms such as
Bain & Company. Mark Sowerby, the managing director, described their
January 2012 IPO as being different in that unlike many IPOs, existing shareholders
didn't sell out. Indeed, if you look at the numbers, not a single share was
sold by directors and executives, and whilst their proportionate stake in the
company reduced due to the issue of new shares, over 65% ownership remained in
their hands after the IPO. Another factor I look at is whether management have
ludicrously lucrative pay packages. In the case of Blue Sky, this doesn't seem
to be the case - no multimillion dollar base salaries here. In addition to the
significant skin they have in the game through share ownership, management are
also incentivised to produce good results for clients. Staff are granted 25% of
the performance fees they generate while the other 75% goes to Blue Sky. As
Charlie Munger likes to point out, never underestimate the power of incentives,
and this phenomenon seems to be at work here going by Blue Sky's investment
results so far.
Perhaps another sign of
confidence in their business is management's decision in the most recent half
year to increase their ownership in their own funds by taking units in their
funds in lieu of cash. While this partially explains the negative 650k net
operating cash flow, one must also consider the nature of Blue Sky's
performance fees which differ between each of its four asset classes. Sometimes these are not paid in cash, even though during the same period performance fees
are recorded as revenue in the income statement. As their prospectus
elaborates: BSA charges a performance fee quarterly where the
performance of the Fund exceeds its designated hurdle rate. In contrast,
performance fees generated by BSPE will be accrued annually (if warranted by
the performance of the underlying investments) but are only received in cash
when investments are exited. Given a private equity investment may be held for
five or more years, the receipt of cash for these performance fees can be
relatively irregular and ‘lumpy’. Therefore, I wouldn't be too concerned
about the negative cash flow as it reflects the nature of performance fees and
management's belief that their current investments are attractive. For what
it's worth, management are expecting 'a significant uplift in performance
fees in the second half of the financial year' (albeit from a level of $0)
and a similar full year result to last year (i.e. $3.5 million NPAT).
Costs are starting to
become a bit of a worry at $4.1 million in 6 months, of which $2.2 million is
for the 35 employees. Given costs are predicted to remain level or fall in the
second half, Blue Sky needs to produce income of $8.2 million just to break
even. I think that this will be quite comfortably surpassed although they may
fall short of $3.5 million NPAT. Again, as AUM increases, these costs will reduce as a proportion of revenue. In a worst case scenario where AUM stays flat over the next 5 years or so, investors are still left with a profitable business at a reasonable price.
Although competition is not
a big concern for Blue Sky right now, it does have the competitive advantage of
being the 'first mover'. They've got all their systems in place, started to
draw more attention from institutional and overseas investors, and have proven
that they can chalk up good results. After all, you can't produce a 6 year
track record in less than 6 years.
Of course, in addition to
the above risks I've mentioned, there are plenty more that I haven't mentioned. Every investor makes
mistakes and Blue Sky are no different, they decided to short the Australian dollar at
around 70 cents after the GFC, but they've made some very prescient calls too,
foreseeing the subprime mortgage bubble and shorting equities in their
subsequent dive. There is also a lack of liquidity in BLA shares, which is a problem for those
unfortunate (or fortunate) enough to be dealing with big money.
Now for the interesting
part, valuation (my apologies in advance for those bored by the maths). As of
this writing, Blue Sky has 32.5 million shares on issue and at $1.25, this
gives a market capitalisation of $40.6 million. Assuming $3.5 million NPAT,
this gives a P/E of 11.6 which is far from expensive but not super cheap
either. With declining AUM, Hunter Hall International (HHL) is still trading on
a forecast P/E of 11-14 depending on their future results, while the esteemed
Platinum Asset Management (PTM) is trading on a forward P/E of 24-28. For a
business such as Blue Sky with such growth potential, I think assuming a P/E of
15 is not unreasonable.
In the most recent half,
Blue Sky received revenue of just over $5 million from AUM that averaged
approximately $200 million (for an annual revenue/AUM ratio of 5%), and remember they received zero performance fees
during this half. If you believe revenue will be higher in the second half (which management says is usually the case), you're looking at revenue of over $10 million. Take away costs of
$8.2 million, add on the icing of performance fees, subtract tax and a profit of a couple of million seems reasonable to expect. I must warn you that I don't really take these figures
seriously, they are very rough guesses. But I'm
not interested in forecasting short term profits, I like to look ahead 5 years
or so.
As previously mentioned,
management are targeting $2 billion AUM in four years. Given their past
predilection for being optimistic, let's take this take this down a peg or two,
to an arbitrary $1 billion. Applying the same 5% revenue/AUM revenue predicted by looking at the half yearly results, this translates
to revenue of $50 million, but that 5% number doesn't seem very sustainable
looking at Blue Sky's peers and previous yearly results. A more conservative measure would be to simply
look at the level of management fees, which varies from 1.5% to 2% of AUM in
the case of Blue Sky. Performance fees, transaction fees and Blue Sky's own
investment in its funds will raise this figure. One necessarily has to take a
stab with the following numbers, but I'll give you my best guess going by peer
characteristics. With $1 billion AUM and assuming a 2.5% cut, revenue would be
$25 million. Subtract costs of around 50% of revenue, apply a tax rate of 30%
and you end up with profit of $8.8 million. At a multiple of 15, this would put
Blue Sky's market cap at $132 million, 3.25 times higher than the current price
in four years, not too shabby. Again, you could play games with these numbers
all day and come up with figures to suit yourself but after analysing possible
scenarios from multiple perspectives and multiple measures that are too long to
list here, I'm satisfied with the risk/reward ratio. For instance, if
management do indeed achieve $2 billion, applying the above process produces a
valuation twice as high for a 6 and a half bagger as Peter Lynch would
say.
Before I keep on rambling
on, I'd better conclude this post. I've allocated 16% of my portfolio to BLA
and now hold 22% of my portfolio in cash. To the right is my latest
spreadsheet. Unless you've got superhuman eyesight, I'd recommend clicking on the image.
Finally, I'll just mention
that it's unlikely I'll be posting anything new on the blog until after the
26th, which is when my exams end.
Of all the characteristics that successful businesspeople and investors have in common, being able to determine the value of an asset is probably the most universal. But this isn't something out of the reach of ordinary people, common sense and basic mathematics are the only requirements. Indeed, every good shopper has some sense of what something is worth, but those who go searching for the biggest bargains are the ones that get the most bang for their buck. Likewise with investing.
