Last month HFA, parent of US-based ‘‘fund of hedge funds’’ manager Lighthouse Partners, announced Assets Under Management and Advice (AUMA) had increased by 8.5% to US$9.48bn over the March quarter alone, a great result for a company seemingly priced for zero growth.
This growth was ‘customised’ mandate wins from a Middle Eastern client and a Japanese client, both starting from 1 April. We initiated a 2.00% position in the Model Portfolio on 13 April.
HFA 31 March 2017 AUMA
Figure 1. HFA 31 March 2017 AUMA
Source: HFA
The GFC was tough for HFA after the company took on significant debt to acquire Lighthouse in 2008. After barely surviving, the group has now recovered quite well though remains poorly understood in our view. To help readers see where the business has come from and understand its much-improved position, we present below charts showing trends for AUMA, debt profile, cashflow, dividends and growth investments.

AUMA growth

As the following chart shows, post-GFC AUMA growth has been steady. By the end of FY17 AUMA should be almost double the level of 2010. Management claims capacity to double AUMA again, with customised accounts expected to drive growth.
In its first 12 years of operation Lighthouse focused on pooled/commingled investment vehicles for wholesale investors, but in 2011 it added customised investment accounts aimed at large institutional clients with US$100m minimum investments. Lighthouse now has 11 custom clients contributing AUMA of US$5bn, which accounts for 53% of total AUMA.
Although customised accounts collect much lower management fees of ~40bps compared to ~120bps for pooled funds, the customised business is more scalable and has strong AUMA growth potential in the ultra-low interest rate environment, particularly from pension funds around the world struggling to match long term liabilities with low risk assets.
AUMA 2009 to FY2017 ($US)
Figure 2. AUMA 2009 to FY2017 ($US)
Source: HFA, Clime

Debt profile

The next chart illustrates how HFA has moved from a significant net debt to a net cash position since 2009. In March 2011 the company issued $75m of convertible notes, with $65m of the proceeds used to pay down debt. These convertibles have either been bought back or converted to equity.
The key point is the current balance sheet strength mainly reflects internally generated cashflow. On 31 December HFA had US$23m of cash and no debt. Learning from its mistake of over-leveraging for the Lighthouse acquisition, HFA is intent on maintaining a net cash position.
Net cash balance ($US)
Figure 3. Net cash balance ($US)
Source: HFA, Clime

Reported earnings vs free cashflow

One thing that can be overlooked if one takes only a cursory view of the P&L is the wide disparity between reported net profit and free cashflow, shown in the table below. The first reason is the amortisation of US$73m of client relationships recognised as part of the Lighthouse acquisition (a non-cash item), and the second is US$118m of deferred tax assets recognised in 2015 (so HFA won’t pay tax for several years). Like other asset managers HFA has a high proportion of fixed costs, so higher revenues driven by extra AUMA should sustain strong free cash flow generation.
NPAT vs free cashflow
Figure 4. NPAT vs free cashflow
Source: HFA, Clime

Dividends and growth investments

Management is now comfortable with the current cash position, which affords room for higher dividends or investments for growth. In FY16 HFA initiated a policy to pay out 70-80% of EBITDA and on this basis we forecast FY17 dividends of US$0.14 or A$0.185 per share. This creates a yield of about 8% (unfranked).
Dividends USD and AUD
Figure 5. Dividends USD and AUD
Source: HFA, Clime
 
Management also intend to add US$2-3m annually to balance sheet investments, which were ~US$15m on 31 December. This includes minority stakes in US fund management businesses 361 Capital, a retail alternative investment manager and Casement Capital, a commodities fund manager.

Performance

To date Lighthouse has delivered consistent returns with minimal volatility. Note returns from Lighthouse’s flagship Diversified Fund below are substantially above the Global Hedge Fund Index across all time periods, while three-year volatility is lower. On a risk-adjusted basis returns are stronger than benchmarks.
HFA performance vs various benchmarks
Figure 6. HFA performance vs various benchmarks
Source: HFA
 
Excluding the net cash balance, HFA is trading at an attractive free cash flow yield of about 11 per cent. Following a review we are happy maintaining our FY17 valuation of A$2.71, a 16% premium to current prices.