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US alt manager buybacks could affect liquidity, leverage, says Fitch

A recent spate of stock buyback programs in the alternative investment management (AIM) sector could have modest impacts on liquidity and leverage, according to Fitch Ratings. 

Three firms have recently implemented share repurchase programs in an effort to improve their public stock valuations. Repurchase activity has been rare in the sector, given relatively limited float, but others could follow suit should they see a benefit to peer valuations.
In October 2015, KKR & Co. LP (KKR) authorised a USD500 million share repurchase plan. Last week, Apollo Global Management, L.P. (Apollo) and Fortress Investment Group LLC (Fortress) announced they would buy back up to USD250 million shares and USD100 million shares, respectively. KKR and Apollo are expected to execute their repurchase plans over time while Fortress will conduct a tender offer, expiring on 4 March, 2016. 
The share repurchase programs are expected to be funded largely with balance sheet cash. While the use of cash reduces balance sheet liquidity without providing incremental earnings for the firm, Fitch believes the repurchase programs are relatively modest within each firm's overall liquidity profile and earnings capacity. 
Along with the share repurchase program, KKR announced a significant dividend cut, allowing retained earnings to fund a meaningful portion of its program. Other firms also have the flexibility to reduce distributions as necessary to augment balance sheet liquidity. Apollo and KKR have been pretty explicit about using balance sheet cash to fund their share repurchase programs, so no leverage impact is expected.
Fortress is also expected to use balance sheet cash to fund at least a portion of its program. However, should Fortress use borrowings to fund its entire tender offer, which is not considered, its leverage would increase to 2.4 times on a pro forma basis, using Fitch's methodology for calculating leverage, which uses fee-related EBITDA in the denominator. This calculation is based on its Sept. 30, 2015 borrowings outstanding and the addition of the USD155.7 million promissory note issued in the fourth quarter. This leverage level is well within what Fitch views as appropriate for an alternative asset manager in the 'BBB' rating category. 
Alternative IMs have historically traded at a discount to their traditional IM peers, based on price-to-earnings multiples. Fitch believes the discount is driven, in part, by limited float and the complexity of an alternative IM's organisational structure and financial reporting. Traditional managers' earnings are derived largely from management fees, while alternative IMs also have the potential to earn incentive income on managed funds and investment income on fund co-investments (in addition to management fees), both of which must be marked-to-market on a quarterly basis and are very difficult to predict. As a result, earnings in the alternative IM sector can be relatively volatile, depending on market conditions.
Incentive income and investment income have been significant in recent years, as alternative IMs have actively sold fund investments into a strong valuation market, but many believe this cycle is coming to an end, which would hurt economic net income and cash earnings over the near term. Still, when market volatility increases, alternative IMs are generally able to find greater opportunities to invest. At present, un-invested capital, or dry powder, in the sector is at record levels, which could fuel earnings in the next realisation cycle. 
The success of the share repurchase strategy could be difficult to assess in the near term as more volatile market conditions are likely to weigh on valuations and share prices, therefore masking the benefit of any program. If share prices go up meaningfully, other firms may follow suit, but some may be more constrained by their amount of float.

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