[APO] Apollo
Most distressed investors merely live in the darkness; Apollo was born in it. Following the epic collapse of Drexel Burnham Lambert, the high-flying investment bank that filed for Chapter 11 in 1990 after pleading guilty to securities and mail fraud, a triumvirate of bankers from the defunct firm – Michael Milken protege Leon Black1 and his two juniors, Josh Harris and Marc Rowan – were quick to seize on the fallout. With the backing of French bank Crédit Lyonnais, the Apollo founders picked up, at deep distressed discounts, the very claims that they had underwritten as bankers and sold to Californian life insurer Executive Life2, minting fortunes on both sides of the credit cycle.
On the back of the Executive Life success, Apollo carried its enterprising opportunism to distressed real estate and corporate transactions, including the buyouts of Samsonite and Vail Resorts. But even the notoriously contrarian and value conscious manager – who typically paid just 6x EBITDA compared to the 8x paid by peers – was sucked into the orgiastic dealmaking vortex of the mid-2000s, a time when all the major buyout shops were drawing on the free-wheeling credit markets and topping each other with ever more aggressive club deals. Apollo, alongside TPG, reached for casino-resort operator Caesar’s at 10x EBITDA using heaps of leverage, with disastrous consequences in the ensuring recession. Perhaps scarred by the experience and wary of the pronounced cyclicality inherent in private equity, they began to mine steadier, recurring sources of revenue, which eventually led them to not just a new asset class but a new structure for exploiting its unique properties.
With far lower yields than the distressed claims that Apollo was used to underwriting, high grade credit doesn’t fit inside traditional fund vehicles that target 20%+ gross IRRs. But the asset class is less cyclical and much bigger, as its relative safety renders it good match for the general accounts of insurance companies who manage predictable, long-lived liabilities.
As you’d expect from a value investor that invests countercyclically, Apollo jumped on life insurance as others were clamoring to get out. Life and annuity insurance is a spread-based business. An annuitant contributes money to an insurer, who invests most of the money in investment grade claims and keeps the difference between what it earns on those claims and what it pays to annuitants. There are countless flavors of annuities (we’ll get into the most popular ones later) but the basic idea is that these products allow consumers to compound savings in a tax-deferred manner, much like a 401(k). During an accumulation phase that can last anywhere between 3 and 15 years, the annuitant’s account grows at a pre-determined fixed rate (fixed annuities) or at a variable rate (fixed indexed annuities or variable annuities) tied to the performance of an underlying equity index. Upon annuitizing the account, the consumer is guaranteed a stream of income payments, for some number of years or until they die, based on their account value at end of accumulation phase. In the meantime, steep penalties in the form of surrender charges and market valuation adjustments discourage annuitants from withdrawing early.
When done right, this should be a steady, predictable business with low blow up risk. But with variable annuities booming in the 3-4 years leading up to the last financial crisis, life and annuity players like Hartford, John Hancock, and Pacific Life began selling riders that offered increasingly aggressive guaranteed benefits over the term of a policyholder’s life, regardless of investment performance, as well as ratchets that reset the benefit base every year to higher levels and roll-ups that guaranteed a certain growth rate in the benefit base. Terms got very competitive while the complex and partial hedging programs designed to protect underwriters broke as volatility spiked and the equity markets collapsed in 2008 and 2009. But these products didn’t fail in the sense that insurers flat out refused to pay out policyholders. Instead, they sold these struggling blocks of business for deep discounts to other insurers, including Athene.
Athene was co-founded by Apollo and former SunAmerica President James Belardi in July 2009 to take advantage of the trouble. Its inaugural transaction, assuming $1.6bn of annuity liabilities from America Equity Investment Life, was followed by a series of larger deals that included acquiring the life & annuity businesses of Aviva USA and Voya3, as well as reinsuring blocks of fixed annuities from Voya, Aviva USA, and Lincoln Financial. Athene redeployed assets transferred to them through these transactions into higher yielding structured securities, picking up extra spread.
But over time, Athene became more than a vehicle to opportunistically acquire policies. Unencumbered by big blocks of souring vintages from pre-crisis times, it was better placed than most to write profitable new business in an industry suddenly deprived of capital. While Athene onboarded annuity contracts, Apollo found places to invest. As the insurer’s sole investment advisor, Apollo would: 1) clip fees on general account assets for handling asset allocation, risk management, hedging, asset-liability matching, and other portfolio functions, as well as 2) earn management and performance fees on the 20% of Athene’s assets invested in Apollo’s funds. Along the way, Athene seeded Athora, a European replica of itself, with Apollo providing similar advisory services.
Following Athene’s December 2016 IPO and series of secondaries and ownership swaps, by 2020 Apollo was Athene’s largest shareholder, with a ~32% stake in Athene4. Athene, in turn, was Apollo’s largest client. But the relationship with Apollo was fraught with agency conflicts. In 2018, The Financial Times published an investigation that “paints a worrisome picture of the governance arrangements meant to keep this conflict in check.” The chief allegation was that Athene was paying above market rates to Apollo for advisory services. Indeed, Apollo’s own internal study found that the ~45 bps of assets it was charging at the time far exceeded the 15-25 bps Athene could pay to an arms-length investment manager. The fee concerns were exacerbated by the fact that Athene’s CEO, Jim Belardi, owned a 5% interest Apollo Asset Management (AAM), the entity managing Athene’s balance sheet. Some investors believed this conflicted relationship was why Athene, despite its generating faster growth and higher ROEs than its peers, traded at a discount. Then last year Apollo acquired the 68% of Athene it didn’t already own at book value (6x earnings), finally resolving the governance issues.