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Brookfield Asset Management (NYSE:BAM) enjoys a distinguished history of compounding wealth for shareholders at an accelerated rate for decades, leaving the S&P 500 (SPY) in the dust over time:
However, it has also successfully launched several partnerships that focus on individual portions within its sprawling investment portfolio. The two most successful of these have been its Renewable (BEP)(BEPC) and Infrastructure (BIP)(BIPC) funds, which have actually significantly outperformed their parent since going public:
Both of these stocks have attracted substantial investor interest due to the fact that they pay out significantly higher income yields than BAM does while still generating strong growth rates. As a result, both of these securities trade at elevated valuation multiples and offer relatively unappealing distribution in the current environment.
However, another partnership issued by BAM – its private equity business Brookfield Business Partners (NYSE:BBU) – has failed to catch on with investors. This is largely due to the fact that it does not pay out much of a distribution yield and has also traditionally issued a K1 tax form. As a result, investors and institutions have had little incentive to buy BBU units since they can just invest in the parent BAM for growth and a similar yield without having to deal with the K1 tax form. That all has changed recently, however, with the advent of Brookfield Business Corporation (BBUC), an economic equivalent to BBU that issues a 1099 tax form instead of a K1. In the short time since it has gone public, BBUC has shown how much greater demand there is for a 1099 issuing private equity company backed by BAM as the stock has outperformed its BBU counterpart thus far:
However, BAM has also seen weaker performance over the past month on rising macro headwinds:
In this article, we will look at these two growth investment opportunities at Brookfield to see which one is the better buy today.
BBU’s unit price has floundered as the partnership is heavily leveraged and some of its businesses took a hit during COVID-19. Meanwhile, even though the economy is reopening and recovering from COVID-19 headwinds, we now are faced with a global economic slowdown, soaring inflation, and rising interest rates. On a heavily leveraged balance sheet like BBU’s this means that refinancing will have an outsized impact on the cash flow statement since interest expense is quite high. It also makes it more difficult to make new leveraged acquisitions since the math will be increasingly challenging. It also might make it more difficult to sell mature businesses at an attractive valuation.
That said, BBU still has a lot going for it that makes it look like an attractive buy today. First and foremost, the valuation looks attractive here thanks in large part to the unit price falling by ~25% over the past six months.
Meanwhile, last year at its investment day, management estimated that NAV per unit had compounded at an 18% rate since the company went public back in 2016. Management has also proven to be efficient at allocating capital as it has consistently opportunistically issued equity at higher valuations and repurchased units at lower valuations while also executing 9 investment exits thus far with an average IRR of ~30%.
Based on last year’s appraisal, BBU’s NAV per unit is ~$37 while its unit price is a mere $24. This implies massive upside potential and we believe there are several catalysts to unlock this value.
First and foremost, management can continue to do what it has done in the past whenever the unit price has strayed too far from management’s view of NAV: buy back units. On the latest earnings call management addressed this, stating:
When we see compelling value in the units, we’ll keep buying…And certainly, with this financing that we’ve just put in place, we’ve got ample flexibility between that and our credit facilities to continue growing. And added to that, of course, ongoing distributions from our companies, monetization proceeds from our companies down the road. We’re very comfortable with our capital position.
Another reason to be bullish here is that the BBUC units trade at a premium to BBU and could continue pushing higher in a similar manner to how BEPC and BIPC traded in the wake of their public listings. The reason why this could be a catalyst for BBU is that BAM may very well get involved to arbitrage the difference between the two. In the past, when BEPC traded too far ahead of BEP, BAM sold a bunch of its equity stake in BEP in the form of BEPC shares in order to capitalize the massive premium. This served to close the gap between the two. If BAM were to do the same with BBUC in the future, it could push the market to recognize that BAM is committed to maintaining a degree of price parity between BBU and BBUC. If that isn’t enough, BAM could literally sell BBUC shares and use the proceeds to buy BBU units.
Another reason to be bullish on BBU is simply that its fundamentals remain quite solid. While it is heavily leveraged, the majority of the debt is nonrecourse and the interest rates are mostly either fixed rate or hedged, as discussed on the latest earnings call:
Analyst: Just on the higher rates. Can you remind us kind of how that impacts the financing cost side of things, just looking out or have you run any sensitivities on a 25 or 50 basis point move, how that impacts your cash flows looking out?
BBU CFO: We have been very focused on interest rate exposure and impact of volatility in rates for the portfolio and been working with all of our businesses… I’d say the first thing is refinancing within our companies…these were all geared towards locking in lower rates. And I’d say, overall, on a consolidated basis that’s probably about $50 million of annual run rate savings for the business…The other thing we’ve been very mindful of is making sure that we’re hedging floating grade exposure. So in the book today, about 65% of our floating rate exposure is hedged. And the piece that’s unhedged is really related to either businesses where we’re paying down debt…[or] in Brazil where just it’s not economical to hedge. But outside of that, 65% of the book is hedged, which provides a strong protection.
The overall kind of cost today of our debt is approximately 4.8% and we’ve got long maturities like five-year average maturity. So we’ve got good protection within the portfolio against rising rates, and we’re going to be mindful moving forward, making sure that we’re hedging rates. You probably saw this morning we had raised the financing for scientific gaming that was $800 million in unsecured bonds and then the balance of about $2.6 billion in term loans. And we raised that at favorable rates and at a cost that’s less than 5%. So we’re still able to kind of execute our financing at very good rates so quite pleased with that outcome…About 65% [of our debt] is fixed today, and that 65% is a combination of where we’ve got fixed rate debt plus all of the hedging that we’ve done on floating rate exposure.
Meanwhile, it continues to grow, with EBITDA expected to increase by 18.7% this year and grow by an additional 9.1% in 2023. With a price to FFO multiple of a mere 3x and a balance sheet that should easily remain solvent (especially given BAM’s backing as an investor with significant skin in the game), BBU is poised to generate massive returns for shareholders if it can continue to execute on its business plans. While current market conditions may slow the pace of compounding due to having a more difficult time with recycling capital, the upside to NAV and organic growth potential as well as the proceeds from the massive cash flow yield within the partnership should all lead to outsized performance over time.
Another pro for BBU investors is that BAM generates incentive distributions equal to 20% of an increase in the volume weighted average unit price of BBU over an established incentive distribution threshold. However, the current incentive distribution threshold is $31.5/unit. This means that BBU unitholders at current prices are set to experience over 31% unit price appreciation before having to give a penny to BAM in incentive distributions. That large of an inventive fee-free upside from a widely regarded franchise like BAM is quite valuable in and of itself. Note that BIP and BEP generated their massive returns net of similarly lucrative fees paid to BAM as well, so BAM has proven that its franchise is well worth the fees.
While it has much lower risk than BBU due to its A- credit rating, tens of billions of dollars in liquidity, and much better diversified business model, BAM also has a bit less upside potential. While BBU has over 50% upside to management’s latest estimate of NAV per unit, BAM does not offer such exciting upside potential.
BAM’s fair value estimate involves assigning a 25x multiple to annualized fee-related earnings and a 10x multiple to target net carried interest.
Based on 2021 numbers, this puts the fair value for the asset management business at $54.6 billion and our fair value estimate for the invested capital business is $52.777 billion. That translates to a fair value estimate on a per share basis of ~$64.
With shares currently trading around $50 as I write this, the company looks clearly undervalued at the current price. This means that the upside potential is ~28%, or roughly half of what is offered by BBU.
Furthermore, similar to BBU, BAM has a key catalyst that could unlock this discount. Management is looking seriously at spinning off its asset management business to try to unlock what it believes is a clear discount in that business. On the latest earnings call, management stated:
As noted in our year end letter, over the past 25 years, we have become one of the largest fastest growing and most diversified managers globally, combined with the fact that we have very long duration annuity life cash flows. Our manager is now of the scale it could be separated out from the rest of our capital.
In a market environment that seemingly prefers its asset-light managers, it may therefore make sense to separate part of the manager and offer investors a security that owns our asset manager separate from our capital. For backdrop based on comparable multiples for pure-play asset-light alternative investment managers, our managers should be valued in the range of $70 billion to $100 billion. This is in addition to the $50 billion of net capital that we have invested in our businesses today.
If we separate part of the manager, this could increase the simplicity and ease of valuing our asset management business, provide a security for those that wish to be asset-light and also possibly open up new growth options for the overall business. As you all know, our business has compounded in an annualized return of 20% for 20 years. Our job is always to continue to invest well, take care of our clients, and review our structure from time-to-time to ensure we unlock value for all shareholders.
BAM is much lower risk than BBU as it holds a substantial stake in all of its partnerships (BEP, BIP, BBU, as well as its recently privatized property partnership (BPY)(BPYU) among other investments) along with a large and rapidly growing asset management business. It also has tens of billions of dollars in liquidity and an A- credit rating.
BBU meanwhile, offers more exciting upside potential with greater than 50% appreciation potential relative to management’s most recent estimate of NAV per unit compared with BAM’s 28% upside to management’s estimate of fair value. BBU also has an extremely low Price to FFO multiple and is using its retained cash flows to pay down debt aggressively and acquire new businesses at attractive valuations. Management has also proven adept at buying back units opportunistically.
While both are strong buys in our view, BAM gets the nod here due to its lower risk in an environment where risk is becoming increasingly expensive to take on. While we think BBU will likely outperform over the long-term from current prices, we are very confident that BAM will outperform over the long-term from current prices. Why take extra risk, when a much surer bet like BAM is poised to deliver outsized returns and has a clear catalyst to do so in spinning of the asset management business?
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This article was written by
Samuel Smith is Vice President at Leonberg Capital and manages the High Yield Investor Seeking Alpha Marketplace Service.
Samuel is a Professional Engineer and Project Management Professional by training and holds a B.S. in Civil Engineering and Mathematics from the United States Military Academy at West Point. He is a former Army officer, land development project engineer, and lead investment analyst at Sure Dividend.
Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.