3 things investors should keep in mind when eyeing opportunities in this asset class

Apollo Global Management’s Eric Hanno is seeing two major trends changing the structure of public markets. 

One of these is the high level of concentration, with 34% of the S&P 500 represented by just 10 stocks trading at 40-50x P/E ratios. The second concern is indexation (and in turn, the rise of passive investing).

“Almost 60% of managed funds in public equity markets today are managed by index funds,” says Hanno.

It all means investors are rapidly having to find alternatives outside of the mainstream to drive returns and Hanno believes that private markets offer a fantastic opportunity.

“If you look at businesses with greater than $100 million in revenue, over 90% of them are private,” he says.

While private equity can be seen as a higher-risk option, Hanno believes that core private equity opportunities offer an attractive replacement for public equity holdings and even an alternative to traditional private equity.

“Instead of underwriting and going for 20% plus returns, maxing out leverage, taking high amounts of risk, we think you can actually buy businesses with maybe slightly less leverage that have more predictable cash flows that you can own for a really long period of time,” Hanno says.

He’s expecting the core private equity allocation in his portfolio to grow in the next few years off the back of opportunities in a more volatile market.

In this episode of The Pitch, Hanno discusses what an equity replacement strategy is and what role core private equity plays within that. He also shares the example of an investment Apollo has in this space and outlines his top tips for investors in core private equity.

Note: This interview was taped on Wednesday, July 17th 2024.

Edited transcript

What is an equity replacement strategy and what makes it different from traditional private equity?

Equity replacement is something that we've started to talk about a lot, and it's really driven by the fact that the structure of public markets has changed quite a bit.

There are two major trends that we would highlight.

One is called indexation, and this stems from the fact that almost 60% of managed funds in public equity markets today are managed by index funds. And that is a trend that has grown tremendously and it has impacts on the market.

Second, there's a trend called concentration. If you look at the US public equity market, 80% of the market is the S&P 500. 10 of those stocks represent 34% of the S&P 500 market cap. And those 10 stocks trade at 40-50x price-to-earnings (P/E) ratio. I think most retirees or people saving for retirement don't think about getting significant exposure to companies that trade at those valuations.

Because of those structural shifts in public markets where they're more concentrated, they're more indexed, people are saying maybe I need to find some equity replacement within my portfolio.

If you look at private markets and you look at the size in terms of the number of companies relative to public markets, it's a fantastic opportunity. The stat I like to quote is that if you look at businesses with greater than $100 million in revenue, over 90% of them are private. If you are looking for a public equity replacement, you should be looking in the private equity markets. 

We believe that there's a segment of private equity markets that is different from traditional private equity called core private equity.

In that (core) segment, instead of underwriting and going for 20% plus returns, maxing out leverage, and taking high amounts of risk, we think you can actually buy businesses with maybe slightly less leverage that have more predictable cash flows that you can own for a really long period of time. We view that to be a potentially very attractive replacement to public equity and an alternative to traditional private equity. 

We think that if in that segment you can deliver low double digits net returns to your investors and you can have a fraction of the volatility or a third of the volatility of public markets, that could be a really nice place for investors to seek out a segment of their portfolio that can deliver a replacement to public equity.

What are the growth prospects of core private equity?

Historically, everyone has thought public equity is safe and diversified and private equity is where you go to take the most risk in your portfolio. We think on a prospective basis, as investors become more comfortable with private equity, they will look at public equity and private equity and say there are segments of both that are riskier and more safe.

And so that more safe segment of private markets is what we call core private equity. We think there's a tremendous growth opportunity as investors start to see the attractive risk-adjusted return profiles of that segment. In our view at Apollo, this is one of the fastest areas of growth that we expect to see in private markets.

In light of that, how much of your portfolio do you expect core private equity to be in the next few years? Are you increasing the allocation?

It is already a large allocation within our strategy and we are targeting somewhere between 40-60%. We are expecting that to increase from where it is today. That’s driven by some of the volatility in markets that we’re seeing today, which is creating a nice entry point to find attractive cash-flowing businesses, where we can buy in at a reasonable valuation, set it up with a reasonable capital structure and ideally own that for a very long period of time.

Can you share some an example of an investment in this space?

Wheels is a fleet leasing and management business. They do three things for companies.

Number one, they help companies buy and sell vehicles. Wheels is actually the largest buyer of Ford F150s in North America. We get a good price on those because of our size and scale, and we share some of those savings with our clients.

Number two, we help manage all the services of owning a fleet of vehicles. If you think about changing the oil or having an engine blowout or replacing a windshield, because of our size and scale, we can do that much more efficiently and cost-effectively.

And the third thing that we do for businesses is we actually help them finance the purchase of those vehicles. So we make it more capital-efficient for those businesses.

We're one of the largest two players in North America, and we've had very low customer churn and very consistent revenues in this business over a very long period of time. What also is very interesting about this deal is that Apollo has been true to its value orientation. We were able to create this business at a very attractive valuation because we combined three businesses to create Wheels. We bought one business out of bankruptcy, and then we quickly did an add-on acquisition of two other large businesses, creating something at scale at an attractive price. And that shows a little bit of the creativity that we try to use within Apollo to create these high-quality businesses at attractive valuations.

We believe that this business - because of the profitability of the business, because of the cash flow profile of the business, we think it's very unlikely that we lose the principal that we invested even in a very tough scenario. 

What are three things that investors should keep in mind about investing in core private equity?

I think the first is the most important when you talk about buying high-quality cash-flowing businesses, that everyone wants those types of businesses. And I think the most important tenet around finding those businesses is [both] not to overpay and to find a way to create those using value. I use this example of Wheels where we used a bankruptcy and a couple of add-on acquisitions to create a nice asset at a reasonable value. And I think that we've done that in a very thoughtful way across all of our core private equity transactions, and I think that's probably the most important consideration.

The second consideration I would say is that if you're going to set up a business that you want to own for a long period of time and you don't want to take excess risk, I think that you should take less leverage at the operating company level. Because if you take as much leverage as you can and if things don't go well for a couple of quarters or a couple of years, you run the risk of losing the principal that you invested. So number two is just to have less leverage.

Then number three, I think, is just to find attractive industries where you think companies can continue to grow steadily over a long period of time. I think you want to avoid industries that are in decline or industries that have a high element of cyclicality.

And so just to recap, try to buy in at an attractive valuation, and you'll probably need creativity to do that. Number two, take reasonable amounts of leverage, and number three, find growing industries or sectors that are less cyclical.

Seeking to provide excess return along the risk-reward spectrum

Founded in 1990, Apollo is a high-growth alternative asset management and retirement services firm. Apollo seeks to provide its clients excess return at every point along the risk-reward spectrum from investment grade to private equity with a focus on three business strategies: equity, hybrid, and yield. Find out more here