No. of Recommendations: 10
The headline news in Q2 was the announced acquisition of American Equity Investment Life Holding Co. (AEL) at a valuation of $4.3 billion. It is expected to close late this year or early next. Brookfield already owned some AEL shares; it agreed to buy up the rest. AEL is one of the largest remaining independent annuity platforms in the U.S., with about $50 billion of float and $400 million of annual earnings.
Brookfield is confident it can invest the float at a higher yield than the annuity products it sells are committed to paying out. If you've ever investigated annuities as a potential investor, you know this is probably true. Annuities generally require customers to pay a high price for certainty.
Along with the earlier acquisition of American National Group, Brookfield says this will make it one of the top three annuity writers in the U.S., with the ability to write $10 billion worth of policies annually.
The five-year plan is to grow the insurance/reinsurance/annuity business to $225 billion of assets by 2027. The AEL transaction gets it to $100 billion. BAM will manage most of the float.
Other notes on the quarter:
* BN repurchased about 1 million shares, taking the diluted count from 1,621.3 million at the end of Q1 to 1,620.3 at the end of Q2. The wording of the commentary on buybacks was largely unchanged: 'We expect to continue to allocate capital towards share buybacks, given the gap between our intrinsic value and trading price.'
* With transaction volumes in the U.S. muted, most dispositions in the quarter were elsewhere. They sold $15 billion worth of assets, including toll roads and office campuses in India for a combined $2.5 billion. By contrast, they made $50 billion worth of acquisitions. Assets under management now total $850 billion, still second to Blackstone, which passed the $1 trillion mark in Q2.
* The AEL purchase is financed in part with $1 billion worth of BAM shares held by BN. So the 75/25 calculation around BAM shares will not be quite so clean as it was. This was not unexpected as BN had said its BAM shares would constitute a worthy currency in future deals. With 25% of BAM valued at $14.5 billion at Friday's close, BN's 75% would be worth $43.5 billion, so using $1 billion worth as part of the AEL purchase would reduce the parent's stake by a little more than 2%. At market prices prior to the bump that followed the Q2 earnings report last week, it would be closer to 3%. At June 30, when BAM closed at $32.63, $2.50 below its Friday close, BN listed the quoted market value of its BAM stake at $40 billion.
* Discussing debt at the corporate level, the quarterly letter to shareholders refers to 'the intrinsic value of our equity' as plus or minus $140 billion, which is consistent with the $138 billion it derives as the 'blended' value of its capital in the Supplemental before subtracting $18 billion of debt and preferred capital, leaving management's calculation of net intrinsic value at $120 billion, up from $112 billion a year ago and more than twice its current market cap.
By contrast, IFRS carrying values put IV at just $40 billion. The biggest difference, as always, is in the carrying value of asset-light BAM, but the public markets also value BIP and BEP at roughly triple and double, respectively, the IFRS values of the assets they hold. Mr. Market values BAM at nearly 6x its IFRS carrying value. Per usual, dispositions in the quarter were at values higher than their IFRS carrying values.
Bruce Flatt closed the Q2 letter to shareholders with a section titled 'Value vs. Price.' Unsurprisingly, it is a discussion of real estate, the primary anchor on BN's share price at present. The reasoning will be familiar to shareholders, but I thought it worth reproducing at a time when the privately-held Brookfield Property Group is so commonly disparaged:
We will end this letter with a final comment on Value investing as it relates to real estate. To ensure we all have comparable terms, Value is what a business or asset is worth based on the future cash flows it will generate. Price is what a business is perceived to be worth, or trades at from time to time, based on prevailing sentiment and other matters. Rarely are Value and Price the same.
Quality real estate is an exceptional long-term asset class which has proven to be that over centuries. It is positively correlated to inflation and therefore protects wealth on a real return basis. With the rapid increase in interest rates over the past year, many are currently questioning these attributes. There is no doubt that there will be pain for those real estate investors whose financings prepared them poorly for these increases.
In addition, real estate always evolves, and owners must ensure that their real estate is relevant for the end customer. This has always been the case, but with constantly evolving work, life, and consumer habits, it is more true today than ever before. Some real estate does not meet this test and therefore must be repurposed.
We believe that great real estate will endure and adjust, and that these interest rate increases will merely be a blip on the Value of great real estate in the long term. We were reminded of this last month when reading our partner Howard Marks' memo entitled 'Taking the Temperature.' On page 9, it includes the following paragraph which is worth considering in relationship to real estate today:
'Watch for moments when most people are so optimistic that they think things can only get better, an expression that usually serves to justify the dangerous view that 'there's no price too high.' Likewise, recognize when people are so depressed that they conclude things can only get worse, as this often means they think a sale at any price is a good sale. When the herd's thinking is either pollyannaish or apocalyptic, the odds increase that the current level and direction are unsustainable. Remember that in extreme times, because of the above, the secret to making money lies in contrarianism, not conformity.' (Emphasis added)
Real estate is a great long-term asset class because it generates real increases in cash flow over time and thus benefits from inflation, rather than suffering because of it. It is important today to remember that interest rates increase once, but rental rates can keep increasing forever, and are positively correlated to the factors that cause interest rates to go up. Crucial, though, to capturing the benefits of the compounding cash flows and inflation protected returns across cycles, is the resiliency of the chosen capital structure and the permanency of the owner's equity capital.
Perpetual and very long-dated equity capital coupled with a conservative capital structure affords the owner patience to realize the Value of an asset with less focus placed on short-term movements in Price. This has always been true and is still true today. It is important for you to remember that our office and retail portfolios are all funded with permanent equity and as evidenced by recent activity, we retain strong access to debt financing to support our investments.
Real estate investors like us, that push through this current environment, will find themselves in a very powerful position once the markets recover. In the interim, as with every cycle, we think there will be some excellent opportunities to acquire some properties on a deep Value basis from owners who are not funded with permanent equity capital, or who have capital structures which cannot withstand this environment.
