Monday, February 25, 2013

What GLRE is Worth to Einhorn

This post is a sort of footnote to my previous post on GLRE.  Think of it as sort of a meditation on the value of incentive fees. I'm just going to think out loud here so I may have some things that may or may not make sense.  I don't claim that anything here is more accurate or new or anything like that.
Anyway, here goes.

What is GLRE Worth to Einhorn?
We know that the hedge fund industry has been looking for ways to raise permanent capital for a long time.  Max Re was started by Moore Capital, for example.  And then we have Greenlight Capital Re.  I have always said that Einhorn is really incented to make this thing work.

If GLRE works out well, this can be really, really good for Einhorn and that's why I think he is going to run this thing really carefully and he is really incented to make it work without blowing up.  Of course, no matter how hard people try, you can't eliminate the risk of something bad happening. 

So let's look at what GLRE is worth to Einhorn. 

Einhorn owns (according to the 2012 proxy) around 6.3 million shares of GLRE (including shares owned by the family trust).  That comes to $155 million.   This should be enough to keep people focused on not screwing up.

But we know that GLRE was set up to raise permanent capital.  So let's see what that is worth.  In the case of GLRE, it's pretty easy to evaluate. 

At the end of 2012, GLRE had $1.2 billion of investments.  All of this is managed by Einhorn (via DME).  The fee structure is straight forward: 1.5% management fee (payable monthly) and a 20% incentive fee paid annually with no preferred rate of return or hurdle rate.  There is a loss carryforward provision, but let's ignore that for now assuming Eihorn can do well over time.

The management fee part is easy to value.  On $1.2 billion in investments, management fees come to $18 million/year.  At the usual 10x multiple, that is worth to $180 million.   The value of this management fee stream alone is worth more than Einhorn's stake in GLRE ($180 million versus $155 million).   If we assume that investments can grow 5%/year through investment returns and/or float growth, this management fee stream can be worth $360 million  ($18 million / (10% discount rate - 5% growth rate).   If they can grow investments at GLRE by 8%/year, then this stream an be worth $900 million.

But then this gets into the argument about the silliness of these cash flow models that go out into perpetuity; who is going to expect GLRE to grow 5% or 8% forever?   (I'm not going to bother with multi-stage models).

You can see, though, why the hedge fund business can be such a lucrative business.  Just moving those assumptions around can lead to some huge numbers.  Anyway, moving on.

Incentive Fee Value
Einhorn gets 20% of the profits without a hurdle or preferred rate.  So this valuation should be easy.  One way to look at this is to think of the manager just owning 20% of the AUM outright.  They get the profits that accrue to that 20% but then don't have to share the losses, so it's sort of better than owning 20% of the AUM outright.  Of course, that doesn't mean there is liquidation value for the manager, though.  But that would be true no matter how you value the incentive fee stream.  You will get a positive value, but in liquidation the manager gets nothing.

But anyway, assuming you own 20% of the AUM is a rough valuation that I use so you don't have to make any assumptions about returns.  This would be a problem with managers that have a hurdle or preferred rate, though, as they don't get paid unless they make their hurdles.  So there may have to be a discount for the years they don't make the hurdles (even though they may make it back over time).

Anyway, the easiest, possibly most accurate way to look at the value of an incentive fee stream is to value it as an option.  You get the upside and don't have to incur losses on the downside.  You don't have to put up any capital up front.  So having an incentive fee contract is simply owning a call option on the AUM (or 20% of the AUM).

And as much as people hate option models, it does work in many cases.

So let's look at what a 20% incentive fee on $1.2 billion in AUM is worth.  The two key inputs in this case is going to be interest rates and volatility of the investments.  Just looking at the annual returns, it looks like GLRE's investments have a volatility of around 14%-18% (was 18% in last five years).

I will just use 15% for now.  The interest rate is an interesting question.  We can just use the risk free rate, but nobody is going to finance a hedge fund position at the risk free rate (after LTCM, I don't know who would finance a stake in a hedge fund at a low rate unless the borrower had other liquid assets against the loan).   So I'll use 3% as the interest rate.  The strike price of the option will be 101.5% (because the 20% incentive fee is paid out only after netting out the management fee, which in this case is 1.5%).

So anyway, here is a matrix of option values, assuming 101.5% strike price, one year term and various interest rate and volatility levels (interest rates of 1%, 3% and 5%; volatility of 10% and 15%):

                             Interest rates
Volatility             1%              3%              5%  
               10%      3.8%           4.8%          5.9%
               15%      5.8%           6.7%          7.8%
               18%      7.0%           7.8%          8.9%

Assuming 15% volatility and 3% interest rate, you get 6.7% in call option value.  One might argue the 15% volatility is too high for a long/short fund as that may be due to the financial crisis.  Equity long/short funds might have more normal volatility of 10%. 

At 10% volatility and 3% interest rate, the call option is worth 4.8%.

So by having this deal with GLRE, the incentive fee value to Einhorn (or DME Advisors) for one year is 4.8% x 20% (you only get 20% of the upside) = 1% of AUM.

This call option is granted every year, though.  So using a discount rate of 10%, this 1% of AUM call option value comes to 10% of AUM (1%/10%).

With AUM at $1.2 billion, this incentive fee agreement is worth $120 million.  Again, this could easily be worth $240 million if we assume AUM growth of 5%/year.  But let's just keep AUM flat.

So summing up all the pieces, this whole GLRE package is worth to Einhorn (and whoever else he shares it with):

Ownership of GLRE stock:   $155 million
Management fee:                   $180 million
Incentive fee:                         $120 million
                                               $455 million

The value of GLRE to Einhorn with the above assumptions is basically $455 million.  The value of GLRE stock that he actually owns accounts for only 1/3 of this total value.

Furthermore, the $155 million of GLRE stock he owns is arguably worth more than a similar amount of his own money he has invested in his funds due to the leverage from float that GLRE enjoys, and the tax free status of GLRE so that book value can compound tax free over time (leveraged and tax free can be pretty powerful).

If you assume that investments at GLRE will grow 5%/year, the above table can be rewritten:

Ownership of GLRE stock:    $155 million
Management fee:                    $360 million
Incentive fee:                          $240 million
                                                $755 million

In this case, the GLRE ownership stake would only be worth 20% of the whole package.

Having said all of that, I do think that this option model valuation is very conservative and is a reasonable lower bound valuation of the incentive fees, particularly the valuation using 10% volatility.  Why?  Because it is a totally blind estimate as if Einhorn's returns will be random going forward. 

But we know that Einhorn and other good hedge funds manage risk actively, so this is sort of a silly assumption.  If we thought Einhorn's returns going forward would be random, we wouldn't invest in GLRE!

I think that the S&P 500 index one year call option value would also be a lower bound valuation.  Why?  Because we expect Einhorn to outperform the S&P 500 index over time.  If someone asked me if I would like to have (for free) a call option on the performance of Einhorn's fund or on the S&P 500 index, it would be an easy decision for me to say I would like the call option on Einhorn's fund.  Right?  If you agree, then an S&P 500 index at-the-money (or 101.5% strike) call option value would be a lower bound valuation for the call option on an Einhorn fund.

Option valuations give credit to volatility regardless of bias; an option holder won't have to take losses to the downside, so the more volatile the underlying, the more valuable the option. 

An active hedge fund (a good one, at least) takes care of the downside and tries to keep volatility of the fund itself low so a normal option valuation would typically undervalue it (in a sense, the better a fund does, the lower the call option value that a model might spit out).

It seems to me that there is a lot riding here for Einhorn in terms of value.   If this works out, it can be really good for Einhorn.  This is why I think he will take a lot of time to make sure it works out.  Of course, there is no guarantee that it works out; history is littered with supersmart people trying very hard and blowing up anyway.

But still, what people think of GLRE will really hinge on what they think of Einhorn.  Those that don't like hedge funds won't like GLRE.  Those that like hedge funds but don't like Einhorn won't like GLRE.  It's almost that simple at this point.

And as for valuation, slightly above book is very cheap if you like Einhorn and think he can do well going forward.  The fact that he hasn't done too well in the recent past may actually be a good thing as there is no froth here, and hopefully Einhorn is getting more focused as a result of his not-so-great performance.  (I remember watching Tepper say his greatest years were preceded by his worst years; so any year he is down is a great time to invest as they perform very well the following year).  It's a no-brainer for Einhorn fans (but again, there is risk here).

Anyway, these are just some thoughts that were floating around in my head over the weekend.  I may notice some logical flaws here and there after posting this, but that's OK.  I think the gist of it is correct even though it may not be of value to many readers (I can already imagine many hedge fund disbelievers laughing at the notion that hedge fund managers can manage downside and lower volatility.   Yes, I remember the big, high profile hedge fund blowups of years past).


  1. Did Einhorn ever provide a postmortem of Greenlight's investment in New Century?

    1. I think he mentioned it in the "Fooling Some of the People" book. Otherwise, he does generally talk about his mistakes in his letters too.

    2. Einhorn just seems a little too wacky for my taste.

      much different disposition from Tepper.

    3. He stated that their analysis of the position was subprime. In fact their investors made money on the position because of wise asset allocation, even though the fund lost money in the end.

  2. Hi

    thanks for the very interesting posts about GLRE!
    What is your opinion about the ratio of Total assets / total equity? Due to diversification effects on the reinsurer side, a big reinsurer like Munich Re will be able to have a ratio of e.g. ~9 compared to GLRE of 3.3 for the same rating (did not check every number now, so the numbers are just roughly right). Without including the underwriting side Einhorn would have to have a ROA of ~3% whereas Munich Re can have only a ROA ~1% that both have roughly 10% ROE. Einhorn has to outperform a bigger reinsurer quite substantially on the invested side. Assuming further that bigger reinsurers are better in underwriting than GLRE this investment outperformance has to be even higher. It looks for me that this is quite a disadvantage for GLRE.
    Very keen to know your opinion in regards to this competitive position
    Thanks a lot, best regards

    1. Hi,

      That's a good point. But in the case of GLRE, the investment returns are really the key. Most reinsurers only invest in bonds so they lever up more. I think GLRE's goal is to invest in a hedge fund but not lever up quite as much.

      When looking at these investment return or double pillar strategy insurance companies (most insurance companies spend their energy on underwriting and just hold a conservative fixed income portfolio against it), what's important is the investment leverage; total investments versus shareholders equity, not total assets to equity.

      In the case of GLRE, looking at the table I put my other GLRE post (2012 results), GLRE wrote premiums of around 60% of equity and had investments of 1.5x equity.

      So even with a combined ratio of a not good 110%, if they earn 10-15% on their investment portfolio they can achieve a 9-17% ROE.

      This is the difference between GLRE and other reinsurers.

      Thanks for reading.

  3. Interesting topic, thx.
    At the core, I'd think Einhorn's GLRE shareholding and GLRE's contribution to Greenlight's AUM plays a core role as to the importance of this entity to Einhorn, tho I agree w/the thoughts in your post.

  4. If these are your random thoughts floating around in your head on a weekend... what exactly are your thoughts like when you *really* concentrate?

    Seriously, great analysis and I am on-board with the options model as a proxy for valuation of the profit incentive on the assets under management.

  5. What if Einhorn gets hit by a bus? How much is GLRE worth then?

    1. GLRE obviously won't be very interesting. It would depend on how they trade out of their positions. The positions seem to be large, liquid positions.

      They would probably try to unwind slowly and not liquidate overnight. In that case, it might not be such a big deal as there is no premium built into the GLRE stock price now.

      But still, it probably won't go *up* if Einhorn got hit by a bus... This would be a problem for his hedge fund investors too, or any entity where you have a key person.

  6. Great article. I like GLRE too although I am a bit concerned of a bit of style drift in Einhorn's strategy recently. The other thing that upsets me a bit is that in a year/quarter when the firm makes a loss and the top management gets no bonus/incentives (Hopefully), Einhorn still gets paid approx $20MM on the magagement fee. Since he is the chairman/major shareholder...this seems to be a bit of misalignment of interest. This is in my mind THE BIG difference between him and Buffet. Bufffet gets pais 100K, period. Everything else he makes is via appreciation of Berkshire. Einhorn has to work very hard to be in the same league!

    1. Hi,

      Yes, the style drift is a bit of a worry to me. I think the whole industry suffers from what I call a Burry/Paulson envy syndrome. A few folks hit huge homeruns on the subprime meltdown and funds have seemingly been looking for the next black swan. I don't think it's gonna work out in most cases. People always seem to try to repeat the last great trade and that leads to problems.

      The good thing, though, is that Einhorn seems to be doing it in a very controlled way, making sure that it's not gonna ruin his year if his macro bets are wrong. But it's still a worry. What the heck is a stock picker doing with 10% of AUM in gold? This makes no sense to me. It would have made a whole lot of sense back in the late 90s and early 2000s when nobody had any interest in gold. But now? Nope.

      As for the management fee, yes, it is what it is. This is how these firms operate. I talk about Oaktree here alot and they take management fees too.

      And by the way, Buffett only takes home a small amount, but we do pay for his private jet, his 20-something HQ staff and many other things too, which would be part of management fees at hedge funds. But still, it would be nowhere near 1% or 2% of Buffett's "AUM".

      Thanks for reading and commenting.

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  8. Maybe I have made a schoolboy error but there seems to me an obvious advantage to investors, not just Einhorn here.

    If shareholder equity is 1bn, and free float is 300mn (rough numbers), he invests 1.3bn. If returns are 10% then the 30mn made on the free float alone will cover most of his 2 and 20 costs (a little over 50mn). Meaning to say, if you bought his fund directly, you lose 2 and 20. If you buy GLRE, you lose much less than 2 and 20 in fees to the extent the free float total returns offset that.