No. of Recommendations: 15
So is it double-counting? I don't think so. At a given moment in time, unrealized carried interest is money you have already earned, whereas target carried interest is money you expect to earn based on future good performance.
The key phrase here is 'At a given moment in time.' This would be the legal standard and I'm sure you're right, they're too smart to violate that, at least in any way obvious enough for you or me to see it.
But our purpose is not forensic accounting. Our purpose is valuation. And we are using all these categories of carried interest because Brookfield management told us to, in a plan value formula it abruptly stopped publishing in the middle of last year. They never said why, but one obvious explanation -- assuming it did not, in fact, come too close to some legal or ethical line -- was that it produced values far higher than the most exuberant market quote. In short, no one believed it.
For a long time, I thought the culprit was the multiple they assigned to fee-related earnings. Particularly for a company with a value sensibility, assigning multiples in the 20s seemed . . . optimistic.
However, based on FRE multiples assigned elsewhere by Mr. Market, including the nascent multiple for the new BAM, something in the area of 20x-25x does not seem out of line. The aspirational 25x-35x of Investor Day may have been a bit backward-looking as the era of free money came to an end, but the multiples offered in the plan value calculation never exceeded 25.
So where was the disconnect? Increasingly, it seems to me it was in these carry categories, where $1 of conceptualized carry translated into $10, then $11, and finally $12 of company valuation.
Imagine I'm $1 of target carry, merely a gleam in my portfolio manager's eye at the beginning, like the imaginary child in the hopeful parent's imagination. Brookfield is so confident in my ultimate existence that it urges investors to value me at $10 in advance (the 10x target carry in the plan value formula). This confidence is based on a period of remarkable growth in assets under management and predictable achievement of performance targets. This growth and performance, in turn, is based on an extended period of exceptionally low interest rates that has devalued traditional fixed income instruments and driven vast amounts of wealth into alternative assets, where asset-level leverage and contracted user payments have made the satisfaction of performance targets so routine as to seem inevitable.
After a long period of gestation as $1 of target carry, I finally graduate (and am reported) as $1 of unrealized carry (the 1x unrealized carry in the plan value formula). Having taken $10 of valuation credit for me over a period of years, my parent now wants an additional face value credit of $1 for me now that I'm in the bag, though still not realized. Are those $10 of target carry subtracted when I cross the Rubicon? Not so you would notice. Target carry continues to grow, inexorably, because the growth in AUM we have seen will inevitably continue, as will the easy achievement of performance targets, indefinitely into the future.
Finally, years after I was worth $10 to the company's valuation, and some more time after I was worth an additional $1 as in the bag, I am finally realized and reported as $1 of income, which is to be valued at some multiple of earnings not specified in the formula.
Alas, I would say that none of this was inevitable and it's less inevitable now, as interest rates rise. One day, the rapid growth in AUM and easy achievement of performance targets will come to an end. Nothing grows to the sky and no financial trends last forever. Is it prudent to value Brookfield on the basis of a formula that requires it to continue as far as the eye can see? Mr. Market's current treatment of alternative asset managers generally suggests he has more immediate doubts.
I am a longtime Brookfield shareholder and a believer in its management team. Like Markel's Tom Gayner, I like that they come to work every day thinking about the whole world. Combined with their value sensibility, this global reach allows them to find value when entire national markets, to which many companies are limited, are overvalued.
Nevertheless, I think their Achilles' heel is a relentlessly self-promotional messaging culture that robs them of credibility in the markets. Can Brookfield be trusted to start lowering target carry levels in time to alert investors to their vulnerabilities? I would not bet on it.
I am glad that they stopped publishing their aspirational plan value multiples and I think we, as investors, should take the hint and stop using them. For myself, I am eliminating carried interest from my valuation exercises. When it shows up as income, Brookfield will get credit for it. That makes a conservative valuation of the parent, Brookfield Corp., a relatively simple exercise:
Determine net invested capital using IFRS values for private holdings and market values for listed subs, make any idiosyncratic adjustments you feel appropriate (as for BPG), then use the market multiple assigned the new BAM for FRE. Let carry be the gravy that allows Brookfield to underpromise and overdeliver, once the mantra of value managers.
Alternatively, reduce their previously recommended target carry multiple substantially to reflect that it represents current conditions and should not be extrapolated too far into the future.
