Brookfield Asset Management: A Classic Special Situation

Sometimes in investing one plus one equals more than two. Brookfield is betting that’s what will happen with their latest spinoff.

On Monday, December 12th Brookfield Asset Management will spin off 25% of its investment management business. The purpose is to highlight the bargain valuation of the asset management business. 

Pre-spin, Brookfield’s ticker was BAM. Post-spin, the asset management spinCo will take the BAM ticker. The remainCo will get a new ticker, BN. I’ll use BAM and BN to refer to the post-spin entities. I’ll call the pre-spin entity Brookfield.

BN will own $53 billion of assets (net of debt) and retain 75% of the asset management business. BN’s assets consist of trophy real estate and mission-critical infrastructure around the world. BN owns many of its is assets indirectly via stakes in perpetual limited partnerships traded on the NYSE (BEP, BIP, & BBU). BN’s assets provide it $3.3 billion of annual dividends, a 6.2% yield.

BAM will own 25% of the asset management business. It will be entitled to 25% of management fees and two thirds of future carried interest. BN will retain 100% of legacy carried interest and one third of future carried interest.

I am not sure why carried interest is split this way. At their recent investor day Brookfield said it is to align interests:

And we're doing this because we believe that creates a really strong alignment of interest for the business moving forward and fortifies the synergies that we're looking to crystallize over time.

Pre-spin, Brookfield trades for $70 billion. Backing out the company’s $53 billion of net assets leaves $17 billion for the asset management business. That’s cheap considering the asset manager has $2 billion of run-rate earnings (8.5x P/E multiple), has historically grown 15%+ per year, and is likely to continue growing rapidly (i.e. replication mode). Management expects to double the asset manager’s earnings power over the next five years.

Asset management earnings are simple and predictable. Earnings come from management fees on capital that is locked up for decades — 83% of fee-bearing capital is long-dated (10+ years) or perpetual. Unlike public securities managers like T. Rowe Price and Diamond Hill, BAM’s AUM is neither subject to volatile mark-to-market changes nor rapid outflows. AUM is invested alongside BN’s capital.

Asset management growth requires no incremental capital so earnings are like an annuity growing 15%+ per year. The business has a long lead time, so growth is highly visible. This week Bruce Flatt said that BAM’s 15% annual growth is already locked in through 2025 and that their focus is on 6-10 years from now.

Our FRE growth targets are already locked in for '23, '24 almost '25. Like this business doesn't happen overnight. It's a very long-tail business. The funds are raised over periods of time they're deployed over three or four years. So you always have that out. So what we're now focused on is what our, let's call it the tale of three years from now, four years from now, five years from now. It will grow at 15% to -- the Asset Management business grows 15% to 20% a year for the next 5 years. So what we're focused on is year six to 10.

Brookfield think their asset manager is worth 25-35x earnings, or $50-70 billion and I agree. The asset manager will also (likely) earn carried interest in the coming years, increasing earnings by several billion dollars.

The intrinsic value of the asset manager plus Brookfield’s net assets is $103-123 billion. At $70 billion, Brookfield’s current price offers a 30-40% margin of safety for a high quality compounder run by proven managers with over $15 billion of skin in the game (20% of the company). At the current price, investors can pay 1x net assets and 8.5x management-fee earnings and get excellent growth prospects, carried interest, and world-class capital allocation for free.

Since BAM will payout ~90% of earnings as dividends ($1.28 per year), investors will either profit from capital gains (if it re-rates to 25-35x earnings) or collect an extraordinarily high dividend yield.

What Is Brookfield?

Brookfield is one of the world’s preeminent alternative asset managers with $407 billion of fee-bearing capital.

Source: Q3 2022 Supplement

Brookfield invests in real estate, infrastructure, credit, private equity, renewable energy, and insurance. The stock has produced a 19% compound return over the last 20 years, double the S&P 500’s return. 

History

Brookfield dates to 1959 when two heirs to the Seagrams whiskey fortune, Edgar and Peter Bronfman, began to invest their inheritance in Brazilian infrastructure and utility assets. They bought Brazilian Traction, Light and Power Company in 1959 and later changed its name to Brascan, a portmanteau of "Brazil" and "Canada." Brascan grew into a conglomerate with interests in “real estate, mining, timberland, hydroelectric power and even things like Labatt Beer and the Toronto Blue Jays” according to Business Breakdowns.

Brascan was ill-prepared for the recession in the early 1990s and had to sell assets and restructure its balance sheet. Bruce Flatt joined the company during this tumultuous period and became CEO in 2002. Brascan’s struggles in the ‘90s led Flatt to adopt a conservative approach that still present today.

Flatt divested Brascan’s cyclical commodity-related investments in mining and timber and spun off the remaining assets as perpetual limited partnerships. Today these trade on the NYSE as BIP, BEP, and BBU and Brookfield continues to own meaningful stakes in each.

Flatt also started an asset management business to manage these perpetual limited partnerships and other outside capital. In 2005 Flatt renamed Brascan Brookfield Asset Management to reflect the company’s new focus.

Unique Attributes

Brookfield has several unique attributes that give it a competitive advantage.

Principals, Not Agents

Unlike most asset managers, Brookfield began by investing its own capital. Its roots are as a principal, not an agent. These roots explain BN’s $53 billion investment portfolio. Brookfield’s ability and willingness to invest its own capital solves a major problem most asset managers run into — what to do with all of the profits.

Asset management is a capital light businesses. A few smart people in a room with computers can manage billions of dollars. Managing $10 billion doesn’t cost more than managing $1 billion, but it is a lot more profitable. Since asset managers don’t need to retain profits to grow, they tend to return all of their earnings to their shareholders as dividends. This is tax inefficient and puts the onus of finding attractive investments on shareholders.

Brookfield’s structure allows it to reinvest profits from its asset management business into its investment portfolio. While this seems simple and obvious, few can do it. Berkshire Hathaway and Markel are the only that come to mind. (Comment below or shoot me an email if you can think of any others.)

Brookfield’s substantial investment portfolio means that it often invests its own money alongside its clients. That’s the definition of skin in the game.

Global Reach

Brookfield operates in 30 countries, giving it a global reach. When the company enters a new country, it does so slowly and deliberately. Business Breakdowns explains: 

Brookfield initially established an office in India in 2009, but it did not close a single investment until 2014. And since then, they scaled their investments. And last year, Brookfield launched and listed a dedicated Indian REIT, which is trading publicly. Fast forward to 2022, they now own something like 40 million square feet of office space, plus a couple of hundred thousand telecom towers and a host of other infrastructure assets as well.

When Brookfield invests it buys multi-billion dollar assets which are often mission-critical pieces of infrastructure. The company must have deep local contacts and goodwill with the government in order to be allowed to bid for, own, and operate such sensitive assets. There are not many businesses which can reinvest profits from Manhattan real estate into a South American pipeline, line up non-recourse financing, and continue to own and operate it for decades. Brookfield can “arbitrage” global markets by moving capital to places where it is scarce (and will therefore earn high returns) from places where capital is well supplied (and will therefore earn below-average returns). This is opportunism at its finest.

Brookfield reminds me of Restaurant Brands International, who likewise have a worldwide network of local franchisees they can tap to rapidly expand a new restaurant concept across the globe. They’ve done it with Burger King and now are working on Popeye’s. Global networks like these take decades to build and are hard to replicate.

Brookfield’s global reach means that they continue to have a large growth runway, despite their already large size. Infrastructure and real estate are two of the largest asset classes world-wide.

Structure

Brookfield’s structure gives it unique options for capital allocation. Since several pieces of Brookfield’s empire are publicly traded —BEP, BIP, BBU, and now BAM — it can selectively repurchase whichever is mis-priced. A conglomerate like Berkshire without any publicly traded subsidiaries doesn’t have this option.

For example, in March and April 2020 Brookfield concentrated its repurchases in BPY, Brookfield Property Partners, which offered a 17-18% dividend yield. Brookfield eventually took BPY private in July 2021. Doing so allowed Brookfield to capture the 25% difference between BPY’s public and private value for itself.

Brookfield’s structure also provides investors greater transparency. Investors can drill into asset-level disclosures in the separate filings of each limited partnership.

Brookfield’s perpetual limited partnerships are a source of permanent capital, which underpin BAM’s earnings power. A third of BAM’s AUM is permanent and another 50% is locked up in long-term (10+ year) agreements.

Source: Q3 2022 Supplement

Brookfield’s structure also allows it to optimize its debt structure at a more granular level than the typical conglomerate. Each limited partnership carries its own debt which is non-recourse to BN. Brookfield explains, “Our businesses are predominantly financed with asset-level debt that is only recourse to the asset and has no cross-collateralization.”

On top of that BN carries a small amount of debt, which is like a margin loan which cannot be called. BN is financed similarly to Bill Ackman’s Pershing Square Holdings in that they own a portfolio of securities leveraged modestly via long-term bonds.

Brand

The people running the world’s largest pensions and sovereign wealth funds are risk averse and would rather allocate to a proven blue-chip asset manager than take a flier on an upstart. No one wants to risk getting fired for modestly higher returns. This gives Brookfield and peers like Blackstone and KKR an incumbency advantage. The big asset managers will probably continue to get bigger.

Strong brands have also prevented the fee compression plaguing public managers from affecting alternative managers. Brookfield still earns 1.5% and 20% on many of its funds.

The Spinoff

BAM is trading for $32, ~24x earnings and a ~4% dividend yield in the when-issued market, in-line with expectations.

However, BN’s when-issued trading price doesn’t reflect the same asset management multiple. BN is trading for $35 and has $32 per share of net assets. That implies just $5 per share for its 75% stake in the asset manager.

Alternatively, BN could reflect the market value for BAM and a discounted valuation of its owned assets.

What Does BN Own?

The table below breaks down BN’s assets using market prices when available and third-party valuations otherwise.

Source: Author, Data From Q3 Supplement

Brookfield Property Group

BN owns $31 billion of real estate. $15 billion of that is core buy-and-hold investments, $8 billion is in real estate private equity funds, and $8 billion is invested in developments that will be sold upon completion. Brookfield expects to earn 9-12% per year for many years from its core portfolio and slightly higher but shorter-term returns from the rest of its real estate.

While rising interest rates, work-from-home, and redemptions at Blackstone’s BREIT have led to concerns around commercial real estate valuations, Brookfield hasn’t seen any unusual in its portfolio. There’s been a flight to quality which has benefitted Brookfield’s office investments.

If the market is discounting anything in BN’s portfolio it is probably the Brookfield Property Group (BPG). Brookfield formed BPG when it took BPY private at a 25% discount to carrying value. The market did not magically remove the 25% discount on those assets just because their ownership changed.

However, there are reasons to believe that Brookfield’s carrying value is correct and that the market is wrong. Over the past twelve months Brookfield has sold $14 billion of real estate at a premium to their IFRS carrying values, including some of the real BPY assets.

Bruce Flatt thinks the market is too pessimistic on real estate and that prices are too low.

Most real estate is in pretty good hands. Look, retail malls were shut down. Their sales, if you have a good multi-day, it's 35% above 2019 sales, 35% above 2019. So like we had worse. Everyone went home and never went to an office building, remember, they were leased, so they're still paying the rent. Retail malls were shut down and hotels, nobody went like -- you couldn't have had anything worse 2.5 years ago, and the business survived and the cash flows are higher and it's growing. And we should just remember price and value. People for some weird reason today, price is lower than the value, they're unsure, so they price it here in the public market.

Publicly Traded Perpetual Limited Partnerships

BEP owns renewable energy assets like wind, solar, and hydro in the US, Canada, Brazil, and Colombia. In October BEP acquired stake in Westinghouse, a leading supplier of nuclear reactors. BN owns 48% of BEP.

BIP owns a variety of infrastructure assets, ranging from utilities to electric transmission lines to oil and gas pipelines. In August Brookfield announced a deal with Intel to build a $30 billion semiconductor foundry in Arizona. Brookfield will provide approximately $15 billion for a 49% interest. Brookfield will source the majority of its commitment from non-recourse debt so its returns on equity component could be very high. BN owns 27% of BIP.

BBU invests in private equity deals. Recent deals include selling Westinghouse to a consortium of investors led by BEP and privatizing Nielsen. BN owns 65% of BBU.

Brookfield Reinsurance

Reinsurance is a relatively new (~18 months old) but rapidly growing business for Brookfield. The reinsurance operation has $10 billion of permanent equity and $40 billion of assets. Brookfield kept $25 billion of those assets in liquid, short-term securities so that’d it’d have dry powder to deploy in case rates rose. They have, and Brookfield is now buying.

Today the reinsurance business earns about $400 million. Brookfield thinks it can double these earnings over the next two years by simply investing its $25 billion of cash-like securities into higher yielding ones.

Brookfield expects that will be able to write $25 billion of reinsurance a year, focused mostly on annuities.

Other Investments

Brookfield explains its other investments:

We have an approximate 4% interest in Vistra [Energy]. In addition, we have direct investments in various operating companies within the Private Equity segment and our share of Oaktree’s balance sheet investments. We owned investments in sustainable resources, mainly timber, and sold our remaining stake in the business in the second quarter of 2022.

Closing Thoughts

Brookfield’s spinoff might offer an interesting investment opportunity depending on where prices shake out Monday. Early indications suggest BN may be cheaper than BAM. That’s wouldn’t surprise me, as BAM is simpler, has a higher ROIC, a higher dividend yield, and faster growth. Many investors will find it the more attractive of the two. But BN shouldn’t be dismissed. It will retain a 75% stake in the asset manager alongside a portfolio of long-lived, cash generative assets. BN aims to earn 15%+ on its owned assets and has done that historically, so it ought to be a steady compounder in its own right.

Flatt expects prices to correct in the next three to six months. If they don’t, Flatt hints that he’ll use buybacks to take advantage of mis-pricings.

I'd say in the next -- as things settle out over the next six -- three, six months, I think we'll be able to tell where what people think of that security. Until then, I don't know. But the bottom line is we're highly incented as management and as owners of the business, just like all shareholders are to ensure that our securities at least trade at a fair representation. And if not, it's the greatest opportunity we can do because we know the businesses.

So unlike many management of some companies that don't understand the arithmetic of what's in the company we price our assets every single day. And so if it trades for a period of time at a big discount, we'll obviously keep buying back stock.

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