Apollo struggles with energy exposure in $3 bln credit fund

Apollo Global Management’s latest credit opportunities fund appears to have gone big into energy ahead of a precipitous drop in oil prices last year.

Apollo was investing in energy, oil and gas in early 2015, after the price of oil had dropped from over $100 per barrel to about $50 per barrel. But oil had a lot further to drop, falling below $30 per barrel in recent months. That’s dragged down the paper returns of Apollo Credit Opportunity Fund III, which closed on $3.4 billion in 2014 and by the end of last fall had nearly a third of its investments in oil, gas and related fields.

The fund was generating a negative 18 percent net internal rate of return as of the fourth quarter, according to Apollo’s year-end earnings report.

Apollo has told Fund III LPs that it lowered its expectations for the fund’s performance, according to two people familiar with the fund. The fund when it launched was targeting a 15 percent gross return, according to documents from the San Diego County Employees Retirement Association. Apollo now expects between a 6 to 8 percent net and an 8 to 10 percent gross return, the firm told Fund III investors on a call in the second week of February, the two people said.

Apollo declined to discuss details of the fund. But on its fourth-quarter earnings call, the firm said many of the mark-to-market judgments used to calculate its performance are based on unrealized returns, suggesting the value of its energy investments could recover. It wouldn’t be the first time investments have bounced back for the firm. Apollo began buying the distressed debt of chemical company LyondellBasell at 80 cents on the dollar during the financial crisis and bought it all the way down to 15 cents on the dollar, Buyouts reported. Apollo eventually ended up making a $10 billion profit on the chemical firm.

There is still capital to invest out of Fund III. It is nearly fully invested, with about $3.2 billion committed, although it has the ability to recycle proceeds. That bumps remaining capital to about $1 billion, sources said. However, the deadline to put the capital to work is running out as the investment period ends in August, according to San Diego County documents. The fund term runs to 2019.

Led by Ted Goldthorpe and Rob Ruberton, Apollo Credit Opportunities Fund III is a distressed investment vehicle earmarked for rescue financings, debtor-in-possession loans, liquidations, leveraged-yield strategies, dislocated structured credit, private lending and mezzanine.

The fund is heavily exposed to energy, oil and gas, though it didn’t start out that way. Pension documents from San Diego County show that as of March 2014, only 6 percent of the portfolio was invested in energy, oil and gas, and 19 percent was invested in metals and mining assets. At that time, the fund had invested about $410 million, according to the document.

The exposure shifted by March 2015, when 31 percent of the fund was invested in energy, oil and gas, according to a fund update document seen by Buyouts. By September 2015, about 28 percent of the fund was invested in energy, oil and gas, 11 percent in transportation and cargo and 4 percent in metals and mining.

Through 2014, Apollo was enthusiastic about energy, according to transcripts from several earnings calls. “Right now, one of our favorite spots is in the energy sector,” Apollo founder and Chief Executive Officer Leon Black said during the firm’s Q2 2014 earnings call.

Apollo appears to have done what many distressed investors fear the most: buying well before the bottom. “I think particularly in energy and natural resources, when you look at it, there was a leg down in oil,” said firm co-founder and Senior Managing Director Josh Harris on the firm’s third quarter 2015 earnings call. “Everyone plowed right into some of the stressed credit names, and guess what? The leg down continued and got worse and people lost a bunch of money.”

The question now is, can Apollo ride out the volatility and bring the fund into profitability. “The option is either to sell assets now and crystalize the loss and if that’s the case, face disaster, or hope and pray it recovers,” said an investor in distressed assets who has worked with Apollo.

Oil prices just keep falling. Even now, with WTI Crude sitting at $27 per barrel as of February 11, no one can be certain where it will bottom out.

Apollo’s first Credit Opportunity fund started investing in 2008 with about $1.5 billion to deploy, backed primarily by one strategic investor, according to a regulatory filing. Fund II began investing in June 2008 with about $1.8 billion, according to the filing. Both funds combined generated a 20 percent net IRR as of the fourth quarter, according to Apollo’s recent earnings report.

Steve Gelsi and Sam Sutton contributed to this report.

Action Item: Read the COF III investment presentation here: http://bit.ly/1KIVyjI

Photo: Leon Black, chairman and CEO Apollo Global Management, speaks at the Milken Institute Global Conference in Beverly Hills, California April 29, 2014.  REUTERS/Kevork Djansezian