Blue Sky Alternative Investments (BLA) is a rising star in the Australian funds management industry. Having listed in 2012 at a market capitalisation of $33m with $200m of Assets Under Management, Blue Sky today manages $2.4bn of assets and is worth roughly $480m in market capitalisation.
Hats off to Mark Sowerby and his team for not only meeting but exceeding their very audacious 5 year strategic goal set out in 2012:
Investment horizon mismatch
What is conceptually interesting about a publicly listed alternative assets manager is the incongruence in investment horizon between investors in the listed manager and the illiquid alternative assets being managed.
As an asset manager, Blue Sky’s raison d’être is to increase the value of the assets it originates and manages.
If Blue Sky performs as advertised, it should earn a material portion of its income from Performance Fees – a portion of the gain in value of its managed assets (typically 20% of excess returns above a baseline return of 8% p.a.).
Now, the nature of alternative assets is such that assets may take up to 5-10 years to realise and in the interim there are typically no directly reference-able market prices for these assets. Accordingly, if one were to operate on the extreme end of the conservatism spectrum, no Performance Fee income would be recognised until the actual assets are realised.
The reality though is that BLA trades daily on the public equities market. Half-yearly financial results matter and few public equity investor will wait 5-10 years for outperformance to be recognised. Hence practically, in the real world, BLA has to periodically determine whether unrealised assets have gained or lost value through valuation reviews. Performance Fee income are then recognised accordingly.
And herein lies the conundrum – asking the question of “how much is this asset worth?” without directly observable market reference points is often akin to asking “how long is a piece of string?”. There is inherent subjectivity in any valuation process meaning that any gains (or losses) determined are never 100% certain until the asset itself is actually realised.
To better understand this, let’s work through some real life examples.
Residential development projects valuations
Although individual fund valuations are not publicly disclosed, we can glean insights into BLA’s valuation process by looking at NTA statements for the Blue Sky Alternative Access Fund (BAF), Blue Sky’s ASX-listed fund of funds.
Let’s take BAF’s portfolio of Brisbane residential development investments as at June 2015 and see how their valuations have evolved since:
It appears that valuation have occurred regularly at each quarter end. The noticeably large September 2015 valuation uplifts are attributable to the following:
In other words, there is a significant valuation uplift whenever residential development projects clear the 4 hurdles above. It’s a significant step-up because the project switches from being valued “at cost” to being valued as a completed project using discounted cashflow.
Blue Sky issued an updated Valuation Policy in January 2016. I could not track down the original Valuation Policy, but of interest is the slight variations to the 4 hurdles above:
Eagle eyed readers will notice that the debt condition has eased somewhat – from requiring that “senior debt is secured” to simply that “an amount of debt sufficient to complete the project is arranged”.
At minimum, this demonstrates how much subjectivity there is in private valuation processes – especially when you get to put together your own valuation policy.
We also see smaller valuation uplifts before the close of FY2016 on the basis of the “projects continuing to deliver on sales targets and construction milestones with no adverse changes to the original forecast returns“:
Interestingly though, some of the above projects have actually fallen behind their original scheduled realisation dates:
Why do valuation reviews matter?
So why do valuation reviews matter?
It matters because the bulk of BLA’s Performance Fee income (which comprises close to 30% of BLA’s FY2016 Revenues) are recognised on the basis of valuation reviews.
As a consequence, there is $24m in Performance Fee receivables outstanding on BLA’s FY2016 Balance Sheet (128% of FY2016 Performance Fee income!), income that have been recognised but not yet received by BLA. Additionally, $10m of these receivables are classified as “non-current” (i.e. not due to be received within the next 12 months).
There are then obvious implications if assets, where Performance Fee income have already been recognised, are later realised at less than their appraised carrying values.
To be fair, I have no reason to believe that these assets won’t be realised at, or even above, their carrying values. Blue Sky appears to be confident:
…and has shown us examples of the big reputable names involved in the valuation process:
Private valuation reviews a necessary convolution
At the end of the day, private valuation reviews are a necessary convolution to reconcile the fact that (1) BLA shareholders need to be able to readily value the publicly traded BLA shares; yet (2) BLA’s value is largely a derivative of the value of illiquid alternate assets.
A major selling point for alternative assets investing is the thesis that illiquidity brings about market inefficiencies that can be exploited by a skilled manager. Then, to be able to periodically realise the appreciated value of these assets without actually realising them, is essentially having the best of both worlds.
At minimum though, we need to recognise the inherent subjectivity in these valuation reviews and consequently how this subjectivity flows through to revenue recognition.
And whenever subjectivity crosses path with financial incentives, it is usually prudent for us as investors to apply an extra layer of conservatism.
Note: The above blog post constitutes the author’s personal views only and is not to be construed as investment advice in any shape or form. Being obviously passionate about the art of investing, the author may from time to time hold positions in the aforementioned stocks consistent with the views and opinions expressed in this blog post. Disclosure – I hold no positions in BLA or BAF at the time of publishing this article.
Nice. I remember looking at these guys back in 2012 as they owned water rights which I was interested in. I never pulled the trigger though and I’ve not looked at them since. I also remember needing to get a valuation done once, and I was happy with the valuation I was provided with. The point is that I was paying the valuer and I was asked what valuation I had in mind. One can only speculate whether this happy coincidence extends to the corporate world.
Well I can tell you that generally in the corporate world, companies/directors pay for 3rd party valuations primarily for the purpose of arse covering, not because they don’t know how to perform a valuation.
I think you are being way too kind in your assessment of BLA. To me it is crazy where the market has priced BLA. The two major risks are uncertain realisation vs valuation, and illiquidity of the assets. It has a structure that is prone to “mark-to-unicorn” type valuation. And on a macro level, if and when the music stops this will be one spectacular blowup. A prudent investor should only buy this at a substantial discount to market multiple… yet it trades at a massive premium.
This was a good article highlighting an issue that all alternative asset managers face (i.e. when to book performance fees, and based on what valuations).
The potential for issues to arise here is obvious given employees of BLA get 25% of their fund’s relative performance fee as their bonus, and what ultimately drives the performance fee of the fund is the (subjective) valuation…and, of course, the 3rd party valuation firm doing the valuation on behalf of BLA knows who’s paying their bills. But there’s an important nuance here in terms of incentives for employees of BLA – while they get as a bonus 25% of their fund’s performance fee, the employees only get paid that bonus in cash when the performance fee is received in cash by BLA. So, an employee of BLA has nothing to gain by writing up the value of an asset really worth $1.50 to $2 a year out from realization (to ostensibly get a huge performance fee bonus), because when the fund sells the asset for $1.50 a year later (and not the fantasy $2 value), the performance fee actually received in cash by BLA (25% of which goes to the employee) will be based off the $1.50 actual sale value. This is a nuance but it’s an important one – there are alternative asset managers who let their employees bank huge bonuses on fantasy asset values BEFORE those assets are realized, which creates very dangerous incentives.
And linking back the above incentive system to actual performance, one omission from your article was BLA’s realization track record – as at 1HFY17, they’ve realized 30 investments since inception, 27 of which were realized above book value. The fact they’ve realized 90% of investments at excess to carrying value suggests their valuation policy isn’t a complete fantasy, and that their employees are responding to the incentives in front of them (i.e. they have no incentive to mark up assets to fantasy values because those fantasy values will never be realized, and thus the 25% bonus on the performance fee generated by the fantasy value will never be received by the employee).
Thank you James for some very good points. One thing I would add here though is that the asset realization track record is somewhat self-selecting given that the best assets are typically the easiest to divest (and vice versa for the worst assets).