NEW YORK (TheStreet) -- Private-equity firms
Apollo Global Management
(KKR) are the best pure-play growth stocks in the financial services sector, Bernstein Research analysts said in a Thursday report that initiated each firm with the equivalent of a "buy" rating.
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Private-equity firms have significant growth opportunities ahead, particularly in real estate and debt investing, which stock investors are giving little credence to, according to Bernstein's analysis.
"We believe the market is undervaluing the going concern value of these firms and the significant growth opportunities ahead, both of which we view as practically free options at current market prices," the analysts said, noting an average price-to-earnings ratio of below 11 for alternative investment firms.
Undervalued growth opportunities, in concert with a strong market for selling existing investments, means that alternative managers may see earnings and revenue rise in coming years, as the traditional financial services sector muddles through a tepid macroeconomic environment and increasing regulatory burdens."The alternative managers' private market businesses are in the midst of a nirvana for portfolio company exits and performance fees," Bernstein said. In 2013, firms like Apollo Global Management accounted for more than 10% of the buyout industry's realization and fundraising activity. Publicly traded alternative asset managers derive their earnings from annual management fees on the assets they manage. The PE firms also generate earnings from the value of residual interests they hold in their funds, which now span private equity, distressed debt and a host of other alternative assets. Rising assets under management provide shareholders in PE firms with some reliable earnings streams. However, it is the prospect of realized and unrealized gains from fund investments, or so-called carry, that often drives the shares of PE firms. However, if firms sell down most of their pre-crisis investments by 2014 and 2015, that could mean there is little left to sell in 2016 and beyond. That "realization cliff," as the industry calls it, may not be so dramatic, according to Bernstein analysts. "We agree that a dip in realizations seems likely in 2016 or 2017, but believe this pause should prove short-lived. Our industry and firm models suggest that, at the current pace of fundraising and capital deployment, investors stand to benefit from record realizations in 2018 and beyond," Bernstein said. Bernstein also said the cyclical nature of the private-equity businesses may moderate as firms expand to new markets like real estate and debt trading. Blackstone on Wednesday issued $500 million in debt in an oversubscribed offering that may give the PE firm added funds to invest in expansion. Where Else on Wall Street? If Bernstein is optimistic about the prospects of alternative managers, that also appears to reflect pessimism for most other parts of the financial services sector. "The broader financial services industry is suffering from stunted growth," Bernstein said, noting that commercial banks sell commodity services, investment banks are hamstrung by higher capital charges and new regulations, and traditional asset managers have limited growth opportunities. In the wake of a tepid first quarter for bond underwriting and trading, analysts are in the process of trimming their earnings estimates for investment banking firms such as Goldman Sachs (GS), Morgan Stanley (MS), Bank of America (BAC), and JPMorgan (JPM). Investment banks are more of a second-half story now, a pretty typical refrain in the years since the crisis. Carried Interest Is a Risk A risk to Bernstein's championing of alternative managers comes from Washington. Currently, PE and hedge fund firms benefit from a so-called carried interest tax rate based on long-term investment returns, and not at the corporate tax rate. However, many in Congress, particularly on the left, have proposed that alternative managers be taxed at the overall corporate tax rate, eliminating carried interest. "We think the chance of any such legislation passing in the near term is remote but potentially very impactful," Bernstein said. In March, Oppenheimer analyst Chris Kotowski highlighted KKR as the most undervalued firm in the alternatives space and cited the emergence of rising carry from firm's flagship 2006 buyout fund. Kotowski calculated that if KKR's 2006 fund were liquidated at current prices, it would generate 89 cents in earnings for public shareholders, and noted that KKR's history for conservative investment raises the prospect of additional earnings. -- Written by Antoine Gara in New York
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