Marc Rowan, founding partner of Apollo Management, one of the world’s largest private equity investment firms, makes it sound simple: Stick to the fundamentals — that is, buy a good business at a low price — and you ultimately will see returns. Of course, identifying those businesses is the challenge. Rowan, who was in mergers and acquisitions at Drexel Burnham Lambert before starting Apollo, spoke with Knowledge at Wharton about how Apollo makes investment decisions, the challenges private equity faces in the coming months, the recent insider trading scandals and what he looks for in new hires.
An edited transcript of the conversation follows.
Knowledge at Wharton: Marc, thanks for joining us.
The value of private company acquisitions fell by two-thirds this year up to July. Things have come back some, of course, but there are still reports that private equity in general will likely face large losses over the next year. And now industry observers are talking about a wall of refinancing coming due in 2012 for firms scooped up by the private equity companies just before the financial crisis hit. How do you see all this playing out?
Marc Rowan: It’s certainly an interesting time for private equity. But I think it’s important to come back to fundamentals. Anyone who has been investing for long periods of time knows the secret to success — which is low price. If you buy a fundamentally good business at a low price, you will ultimately make money…. The irony is we all know this as investors, particularly in private equity, and we have a capital base that’s 10 or 12 years that allows us to pick our spots in time. But it is ironic that with all these industry professionals, and all this capital structure in place, most money is not invested when prices are low. Most money is invested when prices are high. That’s, after all, when there is confidence in the economy, when there is financing, when, quite frankly, businesses want to be sold. The challenge for private equity and investors generally is to have the courage of their convictions, and to come up with strategies for investing when prices are low and liquidity is not available.
For us at Apollo, the strategy that we have relied on for the past 20 years is distressed. Most of the founders of our business come out of the debt business. Rather than looking for acquisitions in the traditional private equity fashion during these periods of time, we employ our fixed income skill set. We go in and we buy the debt, bank debt, subordinated debt, of fundamentally good businesses that are overlevered, and we work through a process with creditors — sometimes in bankruptcy, sometimes out of bankruptcy — and we end up, hopefully, backing into control of a fundamentally good capital structure at a good price.
This has proved to be a very good thing for us. If you look, over the past 20 years, the fund that we raised in 1990 — the foundation of the RTC [Resolution Trust Corp.], the last S&L crisis — better than 50% rates of return. The fund that was raised in 2001, in the wake of 9/11 and the Internet and telecom debacle, better than 60% rates of return. Across our firm over the past 18 months, we have actually invested almost $9 billion of equity — not universally popular with many LPs — who were scared by the volatility in the market — but, we fundamentally believe, the right thing to do.
In terms of the other parts of your question — clearly this will be a difficult period of time for private equity. Many companies were acquired in 2006, 2007, when the sun was shining on the economy, and liquidity was plentiful. There no doubt will be casualties. Companies will go bankrupt; private equity will suffer losses. But I think, again, to put it in perspective, even for someone like us, we have never had a fund where we have not lost money on at least one company. We are, after all, in a risk business. There is no free lunch. And if we are seeking better than 20% rates of return, no doubt there will be some volatility. In terms of wholesale collapse, wholesale panic, refinancing, I believe that to be significantly overstated. Yes, we have this wall of refinancings as an industry. But if you look at what’s happened over the past 12 months, the wall that was there in 2012 and 2013 is now 2014, 2015. The supply of bank debt is shrinking. The supply of bonds is increasing. At the end of the day, fundamentally good companies will find windows in the capital markets to refinance. And I don’t believe there will be wholesale liquidations or losses.
Knowledge at Wharton: Where do you see the best opportunities today in private equity, first in the U.S. and then outside the U.S., in places like India and China?
Rowan: Our purview is really limited to the U.S. and Western Europe for making de novo investments. Clearly, we are aware of the macro factors taking place in India and China. But we have to really look ourselves in the mirror and say, “What is it that we’re bringing?” It’s not as if we have the best local knowledge, and it’s not as if China needs more dollars coming there. So, you have a highly liquid economy with lots of local players. We think it’s best to pick our spots where we think we have a knowledge-based edge. In the U.S. and Western Europe, if I look at what we’ve done over the past 18 months, I would say 90% of what we’ve done has been debt. Initially, when the economy went through a liquidity crisis, we saw a period of time when banks’ balance sheets were bloated with corporate loans that they could not syndicate. For a period of time in the fall of last year, we saw wholesale liquidations of senior secured debt of fundamentally good companies being sold at prices, and in structures, that implied private equity rates of return over long periods of time with senior secured debt risk. In my 25-year career, I had never seen that before. And that was clearly, at that point in time, the best risk-reward.
That phase largely ended at the beginning of ’09, as banks cleared out their back inventory, and markets began to recover. And most of the rest of ’09 was spent buying distressed positions in fundamentally good companies that have then resulted in good equity investments. The two largest examples in our portfolio are Charter Communications, the third largest cable company in the U.S., and Lyondell Chemical, which is just now going through a corporate reorganization. Examples of two very good businesses.
If I were to look industry by industry, the partners in my firm would certainly have a variety of opinions, depending on their background and expertise. Clearly, industry is not necessarily the divining rod for opportunity. I think right now, we are most focused on situations where liquidity, where patient capital, where risk capital, quite frankly, can make the difference and result in attractive asset purchase prices. If I look at our activity, a lot of it has been in financial services — financial services was among the places that were hardest hit by the recent liquidity crisis — and in commodities, where we have seen a tremendous amount of volatility, and players have not had sustainable capital structure.
Knowledge at Wharton: Are there any industries or areas you would stay away from? I know you said you don’t pick industry by industry because it depends on the situation, but are there warning flags you look for, and conversely, what are the industries you have invested in recently?
Rowan: It’s hard for us, again, to pick industry by industry. The way we have set up our firm is, we have grown, organically, a 60-person partnership. The three founders have been together 25 years, and most of the other partners have been together close to 20 years. Each of us has our own specialty. Today, those specialties encompass nine industries. And quite simply, if we think we have a knowledge-based advantage, we’re active. If we don’t think we have a knowledge-based advantage, even if we see a good deal, it’s not really for us. The sectors that we cover most actively are chemicals, metals, distribution and transportation, packaging, media and leisure, satellite, and business and financial services. There are clearly some gaping holes in there. We’ve seen health care be very interesting. But again, not for us. We’ve seen technology be very interesting — again, not for us. I think you will see firms stick to their knitting in very volatile times.
Knowledge at Wharton: Where’s your money coming from these days? Are you finding the same sources you found three to four years ago? And are the conditions different?
Rowan: The money is coming directly or indirectly from both of you. You know, private equity has its glamorous moments. Certainly there’s no shortage of stories and headlines written about some of the leading players. But sometimes I describe my job, particularly to my children: I am a fiduciary money manager on behalf of retirees around the world. At its core, if you sub-analyze our base, we are supporting retirees — teachers, public employees, corporate pensioners. We are — for our international clients, mostly — working for sovereign wealth funds, which typically represent the long-term future of a nation. And we are working for government-affiliated entities in Asia and the rest of the world. Most of these investors have been around in this business as investors for a very long period of time. Clearly, we have had a lot of investor angst over the past 12 months and 18 months, regarding private equity and returns.
It’s an interesting period of time, though. Mostly, as I’ve said, we have seen the best returns following chaos. That’s certainly been true for us, but it’s also been true for the industry as a whole. I’m not sure exactly why limited-partner investors at this point in time have been so vocal in their criticisms of private equity. Private equity, as a whole, last year was down. Levered equities were down. Quite frankly, unlevered equities in the S&P were down. At the end of the day, what we try and do is fit in a niche in a CIO or CFO’s corporate portfolio as they try to match their assets and liabilities. It’s not all that glamorous described that way. But many of our clients have an 8% cost of capital. Today, the bond market’s not providing them 8%. The stock market’s not providing them 8%. The corporate bond market’s not providing them 8%. They’re very wary of going back into real estate, given that the problems have not worked through.
So if you’re a CIO today, what is it you’re investing in? Eventually, alternatives or alternatives in different structures will have to play a large part of their investment portfolios, or they will not be able to meet their selected discount rates. Revisions of selected discount rates are not politically popular. Moving a discount rate from 8% to 4% roughly doubles the liability in a 50- to 60-year plan.
Knowledge at Wharton: Given the recent publicity over Galleon, what’s the line between being a very successful hedge fund and being an insider trading ring?
Rowan: I’m not really sure that there is a line. I think they’re just so different. People who know that they possess confidential information, and trade on that confidential information, have stolen something. It doesn’t need this environment to tell them that. This has been true for 20, 30, 40 years, as insider trading law and insider trading cases have developed. There are many successful hedge funds. There are many smart people. I’m just not sure that it’s even worth the comparison. There are people who step over the line, and people who don’t step over the line.
Knowledge at Wharton: There were stories in the newspaper just this morning about the arrest of 14 people on insider trading charges, even beyond those at Galleon. Do you think the public perception is that insider trading is unbelievably widespread, much more so than reported, and that hedge funds and others will do just about anything to get a competitive edge?
Rowan: Clearly, public perception is an issue. I tell this funny story sometimes — my wife and I are heading to a dinner event. We pull up at this dinner event, and there are protesters as far as the eye can see. They’re carrying placards, and my wife is wearing fur. She goes, “Oh, no. Not fur again.” I said, “Don’t worry, honey. They’re here protesting hedge funds and private equity.” The reality is, private equity and hedge funds have seeped into the public consciousness. And not in a very good way. Just think about this year. Think that this year ended, after everything that occurred, with Bernie Madoff. Bernie Madoff was a pillar of the financial community. This was an insider. This was someone who was part of the establishment, had been reviewed by the SEC. And the fact that we’ve now had Madoff and mini-Madoffs, and [Allen] Stanfords and others, has been tremendously undermining for public confidence in hedge funds.
But I really don’t think it stops at hedge funds. It goes to banks, it goes to investment banks. Public anger at financial firms generally — which are perceived to either have created the crisis or have been bailed out inappropriately in the crisis, or to have preyed on the unwary, or have been unscrupulous — the stories are legion. Today’s arrest of 14 [alleged insider traders] or the expansion of the Galleon probe is just a symptom of the times. There are bad people in every industry. There are bad politicians, there are bad corporate leaders, and there are certainly bad people who run hedge funds. This seems to have been their year, though.
Knowledge at Wharton: Apollo has long been an investor in debt and equities. But now you have announced that you will start a commodities hedge fund in copper, gold and mining stocks, after the worst collapse in commodity prices in 50 years. I know you’ve mentioned that after a catastrophe is the time to get involved. Could you explain the opportunity that you see there?
Rowan: Sure. It’s always interesting how businesses grow. I look at our business, and we have a little bit of an interesting history. The three founders all worked together at Drexel Burnham some 25 years ago. In the ashes of Drexel, we ended up partnering with a government-owned bank, the State Bank of France, the Credit Lyonnais Bank, which put us in business as what was at the time their largest investment. By the mid-’90s, they had $6 billion invested with Apollo, and we had earned them roughly 50% a year. We presented them an unorthodox fund. Out of one fund, we bought equities for control — private equity. We bought debt for control — our distressed business. We bought debt for yield and spread — our high yield and mezzanine business. We bought real estate both for control and for spread — our real estate lending business. All of these businesses, following the demise of Credit Lyonnais, were then broken into private partnerships with distinct management teams and distinct capital bases, because that is how traditional institutions invest, versus the government of France.
But the core that we created, the belief that we created almost by accident, was no Chinese wall. The thing that we have done really well as a firm is run the firm without any information blockages. The way we think about our business is that we have a library of information. That library, today, is very prevalent across eight or nine different industries. In those eight or nine different industries, we have partners who have worked 15 or 20 years. We’ve owned multiple companies, multiple CEOs. We get a tremendous amount of industry information.
One of the sectors that I’ve mentioned that we are very active in is in the metals business. We own aluminum plants. We own metals distribution companies. We own metals resources companies. We therefore possess not market-based metal information, but unique, on-the-ground, customer flow, spot information about what is happening in various markets. Sometimes we monetize that information by making equity investments for control. Private equity. Sometimes we use our knowledge of that business to make good debt investments. That’s the core of our lending business. And sometimes what we do is we blend the two. We see both a trading opportunity as well as an opportunity to run a business that can provide differentiated returns for investors, like a metals hedge fund.
So what we are doing is, we’re simply leveraging the information that already exists within our firm, and expressing it not as a private equity fund, or not as a mezzanine fund or as a debt fund, but as a commodities trading fund. You will see us not just grow a commodities trading fund, you will see us build a commodities private equity business around the same capability.
Knowledge at Wharton: And that includes forays into agriculture and energy?
Rowan: We have announced our first deal in energy, which is the acquisition of Parallel Petroleum, a U.S.-based oil and gas producer. Very complicated capital structure. Had been somewhat overlevered, was facing a bit of a debt crisis. We combined the skills that we have as distressed and capital structure investors with our knowledge of the commodities markets, and ended up, in our view, buying oil at roughly $20 a barrel out of the ground, and hedging it forward such that we have an acceptable and nice return if oil stays at current levels. And we have a terrific return if inflation takes the price of oil up or if the price of oil goes up on its own. I like that risk-reward in this environment, where we’re not necessarily betting on the recovery of the economy or of the U.S. consumer. We’re simply betting that there will, at some point, be inflation — which is something I think is an interesting bet.
Knowledge at Wharton: Other news reports recently have talked about how big bonuses are back for many people on Wall Street, but not for everyone. For example, incentive pay is projected to rise by about 40% for businesses like fixed income and equities, but will drop 15% to 30% for hedge funds and private equity funds, among others. Do you agree with these projections, and how does that affect your hiring and retention?
Rowan: I do think that is the likely outcome this year. If you think about what’s happened, you have had the demise of a number of competitors in the trading business. You’ve seen Merrill Lynch disappear into Bank of America. You’ve seen Bear Stearns disappear into JP Morgan. You’ve seen Lehman Brothers disappear into Barclays. There simply is less competition. And what you’re seeing is, you’re seeing the fattest trading spreads that have existed for a long period of time. I was reading Goldman Sachs’ recent earnings announcement, Morgan Stanley’s earning announcement, Credit Suisse’s earnings announcement. Everyone seems to be enjoying robust trading profits. And since many of the fixed income traders, equity traders, proprietary investors, receive a percentage of the ups within these institutions, I would expect them to do very well.
Within the private equity business, we also are paid primarily on incentives. We receive a share of the profits. Our share of the profits, though, comes not when investments are made, but when investments are sold. This has not been a great year in which to realize investments. Some realizations have occurred. But based on this year versus history, I would expect realizations, and therefore payouts, to be down. That is the nature of our business, and [it’s] appropriate.
The hedge fund business has a little bit different business model. Many of the best hedge funds were down sizably last year. To be down 20% or 30% was not uncommon. Those hedge funds, therefore, need to be up 40%, 50% and 60% this year, just to break even. They operate, in some ways, the same way as a private equity firm, as a percentage of the profits — although they are measured on a year-over-year basis, based on a high-water mark. Many firms, despite having good performance this year, will not have met their high-water mark, or will just have met their high-water mark, so I would not expect substantial compensation within the hedge fund industry, although there clearly will be exceptions that will be picked up in the newspaper.
Knowledge at Wharton: When you hire people, what do you look for in job applicants?
Rowan: You know, it’s always difficult to know. So, I always turn back to my personal experience. I left Wharton in 1984, 1985, and I went to Drexel Burnham. One of the things I did at Drexel was run the recruiting practice. And so I ended up hiring mostly Wharton grads — both undergrads and grads. And when I got to Apollo, guess what? I ended up hiring mostly Wharton grads and undergrads. That was certainly an interesting way to start. And we have not been disappointed. Roughly 40%, 50% of our firm today is still Wharton alumni in one way or another.
What we have discovered is, there are lots of people who are smart enough to do the job. The question is, do they have the desire? And will they fit? Desire is easy for a year or two. Desire over a decade or two decades is much more difficult. Someone has to really have a passion for what they’re doing, to give it all every day for a decade. If I look at the culture that we’ve tried to build, we have, of the big firms, the fewest number of people. That is not because we are incapable of hiring. It is because we believe that we are better off having 55 or 60 really long-tenure, really smart partners. We have avoided the 100 associates who otherwise would be running around. Now, that has cost us, in that we are clearly not staffed to cover every industry in every situation. At the same time, though, in the industries in which we are expert, we have a partner who has generally been doing the same thing for 15 or 20 years. So if they are the partner in the satellite business, they have lived the satellite business for 15 to 20 years. They know all of the CEOs, they know all of the trends. We don’t have to relearn the business. They know what there is to do. It’s just how we’ve gone about our business.
Fit, again, is something that is very important. When you have as many long-tenured partners as we have — and we’ve had de minimus turnover — one of the things we’ve been able to do is create a culture where you can openly disagree, and vocally disagree, and then go out to lunch. So new arrivals come to Apollo, and they go to their first investment meeting, and they are almost shocked to see the three leaders of the firm yelling at each other, in front of each other. There is no investment committee, there is no back room where the senior partners get together and decide what they are going to do. Our belief has always been, the way you learn this business is through experience. And the way you get experience is you see why we make the decisions we make, what the issues are. And you watch us fight it out. Somehow, it has worked for us. I’m not sure it would work for everyone. So when you hire someone, you’re envisioning smarts, desire, but also, are they going to be completely in shock when they see that we run as participatory a culture as we do? Particularly the first time they stand up and have something truly unique or controversial to say.
Knowledge at Wharton: Marc, thanks very much for joining us.