Friday, 14 June 2013

Blue Skies?

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.  

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