In his recent annual letter to shareholders, Jamie Dimon, Chairman and CEO of JPMorgan, bemoaned the extraordinary level of competition in his industry. In particular, he highlighted the rising influence of non-banking players in markets traditionally dominated by banks. “The growing competition to banks from each other, shadow banks, fintechs and large technology companies is intensifying and clearly contributing to the diminishing role of banks…in the United States and the global financial system.”

He’s not wrong. Data compiled by the Financial Stability Board reveals that banks around the world account for only 38% of global financial assets, down from 47% in 2008. The shift is particularly marked in the United States, where banks now account for just 23% of domestic financial assets. Picking up the slack are the “shadow banks” Dimon highlights: a catch-all category that includes investment funds, finance companies, structured finance vehicles, insurance companies – basically any financial institution that is not strictly regulated as a bank. 

Various factors have driven the rise of shadow banks. A big one is the more onerous regulation that traditional banks have faced since the 2008 financial crisis. As Dimon puts it, “Regulations have consequences, both intended and unintended.” One of the unintended consequences is the migration of financial activity outside the regulated banking sector. 

A beneficiary of this trend is Apollo Global Management. As at the end of last year, the firm managed $350 billion of credit assets – more than most banks in the US. As a point of comparison, US Bancorp, the country’s fifth largest bank, has a loan book of $320 billion. Apollo’s credit portfolio covers a range of different assets, from aircraft debt to mid-market corporate loans to residential mortgages. The firm also does larger corporate lending – it lent $5 billion to Softbank, secured by venture capital holdings, and there have been news reports that it is helping Elon Musk finance his bid for Twitter.

Most people who know Apollo at all know it as a private equity firm – the sort of firm we’ve talked about here before. As a shadow bank, though, it has quite a different complexion. In some ways, it looks like a reincarnation of GE Capital, one of the first entities to institutionalise non-bank banking. To anyone with an interest in financial services, it’s a company that’s worth a closer look. 

Life as a Private Equity Firm

Apollo never started out looking to compete with banks. It was founded in 1990 as a private equity firm, albeit one with roots in credit. In February that year, investment banking firm Drexel Burnham Lambert filed for bankruptcy after pleading guilty to six counts of securities and mail fraud. Leon Black, the firm’s head of mergers and acquisitions, recruited a number of colleagues to set up a new firm they called Apollo Advisors.

The recessionary climate at the time made it difficult to raise financing for new leveraged buyouts and so the team harnessed the junk bond expertise they had accumulated at Drexel to look for distressed-to-control takeover opportunities. By buying loans and bonds of troubled companies, Apollo could take control of companies through a bankruptcy reorganisation or other restructuring. If the companies then turned around or improved, Apollo would ride the upside. The advantage of this type of investing is that it secures a low purchase price. As the firm’s current CEO, Marc Rowan, says, “purchase price matters. We care what we pay. Purchase price is a huge determinant of downside protection; it’s a huge determinant of upside capability.” Black and his team were experts in valuation, deal structuring and complex negotiations and so were well placed to pursue the strategy. ¹

The Apollo team raised their first fund within months of launch and a second two years later. Early deals included the buyout of Vail Ski Resorts, Samsonite and Culligan Water. Those first funds ended up returning 3.6x on their invested capital, equivalent to an internal rate of return of 47% before fees (37% after fees). The firm also set up a bond fund, with backing from French bank Credit Lyonnais. The fund acquired an entire $6 billion portfolio of bonds from Executive Life via auction, at a price of $3 billion. As the economy recovered, the value of the portfolio repriced upwards. The returns captured across that portfolio and the first two funds cemented Apollo’s reputation. 

Although Black was the most senior of the founding team, partners Marc Rowan and Josh Harris rose to run the firm alongside him. The firm was described as “a dysfunctional family with all that implies.” Partners competed directly for capital which led to clever deal making but – according to Max Frumes and Sujeet Inap who write about the firm in their book, The Caesars Palace Coup – few employees forged close friendships at work. Outside the firm, the team became known for being brilliant, unrelenting, and fearless. “And if that rubbed other people the wrong way, that was their problem.”

When it went public in 2011, Apollo had $68 billion assets under management, split roughly between 60% in private equity, 30% in the capital markets segment (where the Executive Life portfolio had sat), and 10% in a fledgling real estate business. Not all funds did as well as the first two – the third and fourth funds raised in the late 1990s returned only 1.8x on invested capital, equivalent to internal rates of return of between 11% and 18% before fees. But subsequent funds did better, especially those raised during market downturns such as in 2001 and 2008. The firm stayed close to its legacy: from its founding through to IPO, approximately 44% of the firm’s private equity investments involved distressed buyouts and debt investments.

It took the 2008 financial crisis for Apollo’s strategy to deviate meaningfully from other private equity firms. “All of the large alternative firms today started life the same way,” explained Marc Rowan recently. “We started as private partnerships in the private equity business. If we were successful in that, we got to be large private partnerships in the private equity business. And if we didn’t screw that up, we were trusted by investors to diversify across a bunch of different asset classes. And if we didn’t screw that up, we got to go public. That’s where the similarity and the business strategy of the publicly traded peers really ends.”

Becoming a Shadow Bank

In the aftermath of the financial crisis, Apollo spotted an opportunity to diversify into insurance. In 2009, under the stewardship of Marc Rowan, the firm formed a new retirement services platform called Athene, whose assets it would directly manage. Through a series of acquisitions, Athene grew into a major provider in its field, fuelling growth at Apollo. Then, last year, the two businesses merged. We discussed the transaction in our most popular piece to date, Other People’s Money. By merging an insurance balance sheet with an investment manager, the firm replicated a strategy pioneered by Warren Buffett many years earlier. “Yes, there are elements of Berkshire Hathaway,” said Marc Rowan at the time. 

Unlike Buffett, Apollo doesn’t invest insurance funds in equities, it invests them in credit. That’s by design – credit is in the DNA of the firm and its insurance strategy reflects that. Athene offers retirement savings solutions like annuities which offer customers a regular guaranteed income in retirement. This gives the firm long-dated, predictable liabilities. The weighted average life of Athene’s liabilities is almost nine years, and almost all liabilities are either non-surrenderable or protected by surrender charges. Over the past three years, the cost of these liabilities has been 2.77% which means that to make money, Athene needs to earn more than that on its assets (plus 0.48% to cover operating expenses and taxes). This is where Apollo comes in. ²

“What goes on to the balance sheet of a retirement services company is different than what goes into a fund. What they want is they want excess spread, but they don't want to take a lot of risk. So if you think about what a retirement services balance sheet is good for, it’s a terrible place to take credit risk. It’s a terrible place to take equity risk. It is a wonderful place to take liquidity and structure risk.”

To deliver that excess spread – Apollo targets 0.30% to 0.40% over peers – the firm scours a broad range of assets. Asset classes are targeted for their illiquidity premium or a structuring premium rather than for incremental credit risk. Over 90% of the portfolio is invested in investment grade fixed and floating assets, and stress testing ensures that risk is contained. 

Assets are sourced in two ways. In one, the firm’s large scale gives it access to asset flows. Apollo has done some pretty large, complex deals over the past year including transactions for Hertz, Abu Dhabi National Oil Company and Softbank. Overall scale has been boosted since the firm rolled out its strategy to third parties, enabling them to invest alongside Athene (and Athora, Athene’s European sibling). Out of the $350 billion the firm now manages in the strategy, $100 billion is from third parties. 

In addition, Apollo has been investing in origination platforms. The firm wants to begin each year knowing that it’s got a pipeline of spread product coming onto its balance sheet to apply to its liability stream – making it less reliant on paying retail prices via Wall Street underwriters. By cutting out intermediaries, the firm is able to lock in higher spreads. 

Over the past few years, Apollo has assembled a portfolio of over ten different origination platforms, some of which were acquired from banks and other financial institutions. They include MidCap and Redding Ridge in commercial finance; Apollo Net Lease and MaxCap in real estate; PK AirFinance, Merx Aviation, Donlen and Haydock in transportation finance; and Foundation, Newfi and Aqua in consumer finance. In aggregate, its platforms employ 2,000 people. As Marc Rowan says, “this is not a business of smart people behind screens” – it requires direct contact with borrowers. The origination platforms currently generate around $100 billion of credit a year which the firm projects can increase to $150 billion. 

Marc Rowan has an interesting take on this strategy of seeking out new assets:

Our market sometimes loses sight of what’s in short supply. Capital as a general matter is plentiful, and it is assets that offer appropriate risk rewards that are in short supply. Therefore, we are incredibly focused on growing our capacity to originate assets that offer attractive risk rewards. They are, in fact, the limiter on our growth rather than the capacity to raise money.

Finding a balance between capital on one side and investment opportunities on the other is a challenge all investment management firms face. Some hedge funds in particular limit the capital they take because assets that offer appropriate risk rewards are in short supply. Renaissance Technologies’ flagship Medallion fund, one of the best performing funds in the world, is famously closed to external capital, as we discussed in Zuckerman’s Curse and the Economics of Fund Management; it is an interesting question how its returns would compress if the fund opened up.

Sometimes, investment firms show less discipline and let rip – largely because their economics incentivise them to grow the capital side of their ledger. Hedge fund manager Paul Marshall tells the story of Mercury Asset Management in his book, 10½ Lessons from Experience. His colleagues there “grew their equities business to be the largest and most successful in the UK, but then grew to be simply too big… Eventually (in 1998) the firm’s UK performance blew up completely.”

The main way round this is to expand the opportunity set by finding – or creating – new assets to invest in. Multi-strategy hedge funds do this via more “pods”, passive investment managers do it with more ETFs benchmarked against more indices; Apollo is doing it by originating new credits. 

The difference is that Apollo looks to source assets traditionally originated by banks. Its opportunity comes not only from regulation chasing many of these asset classes away from banks, but from people leaving those banks. In the old days, as Marc Rowan says, “If you ran trade finance at BNP…you and your 20-person team had two career options. You can go to a U.S. bank, you go to a Japanese bank. Those were your career options.” These days, “you come to Apollo with your team… you and your 20-person team can set up an independent entity, Apollo Trade Finance, you can own a piece of it. We will compensate you based on production net of credit losses over a long period of time, and you can retire 5, 10, 15 years with a piece of the business liquefied, bought out rather than a watch.”

This has been done before, at least on the asset side, albeit not with quite the same incentive structures in place. As Rowan says, “Without the cautionary tale, it looks a lot like GE Capital a long time ago. And that’s not by accident. GE Capital in its day was the single-best originator of secure senior but less liquid assets that offered increased spread.”

Reincarnation of GE Capital

Yet GE Capital is indeed a cautionary tale. Like Apollo, under successive CEOs Jack Welch and Jeff Immelt, GE Capital was able to attract some of the best people in the finance world. “They cultivated the wizards of finance who didn’t want to be on Wall Street but were attracted to working at one of the world’s biggest and best multinational corporations while essentially operating a high-powered hedge fund.” That’s according to Thomas Gryta and Ted Mann whose book, Lights Out, charts the fall of General Electric (GE). 

GE Capital grew its balance sheet from less than $200 billion in 1995 to $425 billion by the time Immelt took over as CEO in 2001, and $565 billion at the dawn of the global financial crisis at the end of 2006. At one stage, GE Capital’s assets effectively placed it as the seventh-largest bank in the country. Like Apollo, GE Capital bolted on more and more origination platforms. It bought commercial finance assets from Boeing, inventory financing from Bombardier, private-label credit card assets, middle-market financing and much, much more. 

“The search for returns was never ending,” write Gryta and Mann. “Capital was constantly on the hunt for deals to finance, assets to buy, and businesses to run. From taco stands to ocean freighters, they were putting GE’s money to work.”

But a number of problems served to undermine GE Capital. First, it grew too large. The unit could get higher returns only by shouldering more risk, causing it to go after acquisitions or new lines of business it earlier may have rejected. This became an issue because the business was run for earnings rather than for spread. General Electric itself prided itself on always making its numbers and GE Capital provided the mechanism to deliver that.

Second, its travails in the financial crisis alerted regulators to the risks inherent in the business and they began to regulate it more like a bank. Having argued for years it wasn’t a bank, it needed to count as one to get bailout funds. But that had a long-term cost. “GE executives threw around the unprovable estimate of $1 billion a year in new costs to meet the compliance requirements dictated to them by the Fed’s bank examiner teams.” 

Finally, renewed competition after the financial crisis led to strategic question-marks over its future. “The wrinkle in the story at General Electric was the new relevance of a question that not even the near-destruction of the company had prompted, but that seemed germane now that GE Capital’s margins were flagging and its usefulness in managing corporate earnings was waning: was GE Capital really worth the trouble anymore?”

Marc Rowan of Apollo proposes another cause for the downfall: “If one looks back and thinks about some of the problems that GE and other concentrated originators of spread found, they relied too much on too few businesses.” Looking at GE Capital, it’s not clear that’s true. Rowan argues that 15 to 20 origination platforms is sufficient to diversify risk, but GE Capital had as many. 

Nevertheless, there are some fundamental differences between the two. Through its insurance business, Apollo has a resilient funding base, making it less reliant on capital markets to raise funds than GE Capital. The firm is run for spread, not for absolute earnings. And while there was speculation that neither Welch nor Immelt really understood the financial services business, that can’t be said for Rowan. 

One feature the two firms do have in common though is complexity. GE Capital got mired in it; Apollo thrives on it. Apollo’s willingness to embrace complexity has been the source of a lot of value the firm has created over the years. “One way we create growth for a reasonable price is complexity,” proclaims Rowan. The Caesars Palace Coup recounts the story of how Rowan and his team navigated the intricacies of the casino operator’s highly complex restructuring. 

But complexity can also court risk. Apollo skated very close to the boundaries of the law in its management of Caesars. Twenty five years earlier, the acquisition of the Executive Life bond portfolio led to legal problems for Apollo’s co-investor, Credit Lyonnais. And until the full merger, which completed earlier this year, Apollo’s relationship with Athene was riddled with conflicts. 

There’s a saying people say: “too clever by half”. Apollo’s success has so far proved it wrong, but it’s only getting started.