Thank you for standing by. This is the conference operator. Welcome to the Brookfield Asset Management second quarter 2017 conference call. As a reminder, all participants are in listen-only mode and the conference is being recorded. After the presentation, there will be an opportunity to ask questions. To join the question queue, you may press star and one on your telephone keypad. Should you need assistance during the conference call, you may signal an operator by pressing star and zero. I would now like to turn the conference over to Suzanne Fleming, Managing Partner, Branding and Communications. Please go ahead, Ms. Fleming.
Thank you, operator, and good morning. Welcome to Brookfield's second quarter conference call. On the call today are Bruce Flatt, our Chief Executive Officer, and Brian Lawson, our Chief Financial Officer. Brian will start off by discussing the highlights of our financial and operating results for the quarter, and Bruce will then give an overview of our market outlook and Brookfield's investment approach. After our formal comments, we'll turn the call over to the operator to take your questions. In order to accommodate all those who want to ask questions, we ask that you refrain from asking multiple questions at one time in order to provide an opportunity for others in the queue. We'll be happy to respond to additional questions later in the call as time permits.
I'd like to remind you that in responding to questions and in talking about new initiatives and our financial and operating performance, we may make forward-looking statements, including forward-looking statements within the meaning of applicable Canadian and U.S. securities laws. These statements reflect predictions of future events and trends and don't relate to historic events. They are subject to known and unknown risks, and future events may differ materially from such statements. For further information on these risks and their potential impacts on our company, please see our filings with the securities regulators in Canada and the U.S. and the information available on our website. Thank you, and I'll now turn the call over to Brian.
Great. Thank you, Suzanne, and good morning. We reported $1 billion of funds from operations, or FFO, for the second quarter, and that compares to $637 million for the 2016 quarter. Net income was $958 million, just shy of a billion dollars, up from $584 million in the same quarter last year. Breaking the FFO down into its key components, fee-related earnings increased by 22%. That's due to a higher level of fee-bearing capital and growth in unitholder distributions. FFO from invested capital increased by 2%. We had good growth from operational improvements at existing operations, although some of this was offset by the impact of lower currency exchange rates on our non-U.S. operations. Realized disposition gains totaled $464 million compared to $123 million in the 2016 quarter. Net income also benefited from a higher level of fair value gains than 2016.
Turning to our asset management operations, fee-bearing capital increased to $117 billion. We had net inflows of $15 billion over the last 12 months, and that drove a $32 million quarter-over-quarter increase in fee revenues. Incentive distributions were higher as a result of increases in distributions to unitholders of our listed funds. We recorded $25 million of performance income from Brookfield Business Partners, representing our share as manager of the increase in BBU's unit price. Increases in transaction and advisory fees were largely offset by a lower level of catch-up fees compared to 2016. All in all, quarterly fee revenues increased by 21% to $353 million. That's $1.2 billion over the last 12 months. Fee-related earnings totaled $732 million over the last 12 months, and that's up by 15% from the amounts at this time last year.
Fee revenues are now tracking at an annualized rate of $1.2 billion each year. In terms of carried interest, we generated $477 million over the past 12 months based on investment performance in our funds, and that brings total unrealized carry to $1.2 billion at June 30th. As a reminder, this is the amount of carry we would expect to be paid if we wound up all our funds at that date. As a point of reference, on a simple straight line basis, what we refer to as target carry, we would expect the existing funds to accumulate carry at roughly $860 million each year based on their target rates of return. The actual increase at this stage of the game tends to lag somewhat while the funds are being invested.
As we have noted before, we don't book carry in our FFO until the funds are largely wound up, which will take some time as our larger funds were raised fairly recently. To highlight the point, as at June 30th, roughly half of our carry-eligible private fund capital is still in the process of being invested. It's dry powder. It was invested fairly recently. Turning to FFO from our invested capital, we experienced significantly higher water volumes in our renewable power operations, which led to a significant increase in generation and FFO. This was partly offset by the impact of continued low prices in North America. Infrastructure results benefited from operational improvements and the contribution from new operations.
Our property operations experienced similar increases in FFO, although this was somewhat offset by the impact of recent sales of core office properties, which reduced net operating income from these assets as we no longer own them. Within our private equity operations, we experienced improved commodity prices, which gave rise to better results from these operations. This was offset by lower FFO within our construction business and our residential business in Brazil, as well as a lower interest in these operations following the spinoff of a portion of our interest in Brookfield Business Partners last year. Realized disposition gains in both quarters relate primarily to our ongoing strategy of selling interest in core office properties in mature markets at favorable values and redeploying the capital through our opportunity funds into properties and other asset classes and geographies with higher return potential.
Lastly, before handing the call over to Bruce, I will confirm that the board of directors declared the latest quarterly common share dividend, $0.14 per share, payable at the end of September, and unchanged from the June dividend. With that, I will hand the call over to Bruce.
Thank you, Brian, and good morning, everyone. As Brian noted, Q2 2017 was a strong quarter. Our asset management fees continue to grow at a rapid pace, and most of the operations we have achieved plan. Most importantly, the market for selling mature property and infrastructure assets continues to be very positive, and we've been using the environment to monetize assets and recycle capital where it makes sense. At the same time, though, we continue to put significant amounts of capital to work, largely targeted at markets that are out of favor or in businesses that require our operating expertise to either grow revenues or to rework cost structures in order to enhance returns. In total, we invested about $9 billion during the quarter. This included a regulated gas transmission business, a road fuel distribution company, a water distribution business, and various real estate properties globally.
At this stage in the business cycle, we're also very focused on enhancing and de-risking cash flows in all of our businesses through operational improvements. Turning to the global investment market for alternative assets. As this market grows and matures, we continue to adapt our investment products to meet client needs. We primarily offer 2 types of products. First is opportunistic return ones, and the second are core products. The former is an alternative for traditional equity investments, the latter for fixed income investments. In each of our business sectors, we continue to grow our funds and expect to have large-scale opportunistic funds of $10 billion to $20 billion for each of our business sectors. Our clients consider these substitutes for equities in their portfolios, and the returns we earn for them are a welcome respite from low return or more volatile liquid investments.
Increasingly, institutional investors, though, are also looking for alternatives to supplement the return on their fixed income portfolios. Since with a 2.25%-3.5% long U.S. Treasury rate, they also need to earn higher returns with this capital while taking more moderate risk. In response, we have been growing our credit businesses and have also started to focus on private, perpetual long-term entities to enable our clients to own these type of assets. In particular, we recently established a private core plus fund focused in real estate in the U.S. Given the size and scale of operations, we believe that over time, our core real estate products could exceed $50 billion. We've also been considering this product for long-duration renewable energy and infrastructure assets, which we think are ideal also for our clients wishing to match liabilities.
Infrastructure and renewable power assets are also particularly suited for perpetual capital investors. Longer term, each of these businesses should also be able to grow to the scale that I just mentioned on real estate and be highly complementary to our operations. Before taking questions, we thought you might be interested in what we're seeing in the U.K., which has continued to capture the news of the day with the political negotiations of Brexit. Despite the headlines, virtually all of our businesses are doing well. We have a number of office buildings under construction in the City of London, and leasing continues to be strong. Since Brexit, we signed a major law firm to over 200,000 sq ft at our 100 Bishopsgate project, and we're progressing construction of a number of major residential rental projects and other office projects, which are substantially fully leased.
Our electricity, gas, and fiber connections business in the U.K. is robust. Sales volumes are up 16% over last year as housing sales across the U.K. continue to be strong. Our Center Parcs hospitality business is effectively 100% occupied and cash flows continue to grow. Our port on the East Coast is seeing solid volumes. Our industrial warehouse property business is very strong with internet deliveries driving growth, and valuations on industrial properties are at all-time highs. Specifically on real estate prices in the City of London, for major high-quality office properties there, at least 30% higher than pre-Brexit. Lastly, while the full impact of Brexit on the U.K. is still unknown, our view continues to be that the effect will be moderate and that London will remain one of the great global centers of commerce for a long while.
We have not seen any major distress opportunities as a result of Brexit, and we do not know if we will. If business weakness appears over the next few years, we will use it as an opportunity to continue to expand our operations as we have in the past at these moments. Operator, that completes my remarks, and I'll turn it over to you, and Brian or I would be pleased to answer any questions if there are any.
Thank you. We'll now begin the question and answer session. To join the question queue, you may press star 1 on your telephone keypad. You will hear a tone acknowledging your request. If you're using a speakerphone, please pick up the handset before pressing any keys. To withdraw your question, please press star 2. We will pause for a moment as callers join the queue. Our first question is from Cherilyn Radbourne of TD Securities. Please go ahead.
Thanks very much, and good morning. Wanted to touch on a couple of things that are mentioned in the letter to shareholders. I guess firstly, you talked about having large-scale opportunistic funds of $10 billion-$20 billion across each of your major business sectors, and effectively you're already there in real estate and infrastructure, and it's private equity where you have a good investment track record, but not the same scale. I just wonder if you could speak a little bit more about how you plan to scale up your private equity business.
I guess two things. Thanks for the question. First of all, I'd just say that we continue to build out the business. We launched our Brookfield Business Partners last year to be able to assist in that. So far, that's gone well. The size of transactions that we're doing because of that and because of our balance sheet is much larger than what the fund we have would normally do. Therefore, we think this next fund will be substantially larger than the fund we have. I would note maybe secondly, that the number, that $10 billion-$20 billion didn't have an indicated time period on it. Our goal is to have that in all the businesses that we operate to give us the scale.
Secondly, with respect to perpetual private funds, which does seem to be an industry trend and one you've already tapped in real estate, can you talk about what you see as the major pluses and minuses of closed-end fixed life funds versus perpetual funds?
Well, the perpetual fund, I'll try to answer your question. If I don't get it right, please ask me again. I would say, for opportunistic investments, generally what people are buying into is that you're investing the money for them, and you'll return it within a 10-12 year period. Generally, it's a seven-year average life of investment, call it. With a more core product, what people want is it's a form of investment to otherwise own a direct interest in real estate or power or infrastructure. We own it for them, and we have it through a fund, and it's mixed with diversification, but it's like owning real estate as a perpetual investor buying a piece of real estate. Therefore they just buy it, and it's owned for a very long period of time.
The fees and the incentives of the managers are set up to have very long duration capital invested, and therefore, the investors get the benefits of owning a piece of infrastructure or real estate. They don't have to sell it, and they can stay invested. The incentives are all aligned that way, but their returns are lower, and that's why, I guess, we indicated that it really is benchmarked off of fixed income alternatives versus others. Large investors may do it themselves, but most investors don't have the scale and diversification capabilities to do it other than these type of products that we're creating.
That's all my questions.
The next question is from Ann Dai of KBW. Please go ahead.
Hi, good morning, thanks for taking my question. My first question is around the capital commitments with your private fund business. I guess I'm wondering, does the fact that each listed partnership have commitments to invest in these next gen private funds that are getting successfully larger create any situations where the partnerships can become limited in their ability to invest in other opportunities that they're seeing? Is the cash flow from prior funds sufficient at this point to fulfill those commitments? If not, what are the levers that you can pull, whether it's taking down the proportion of their commitment or having BAM provide liquidity in some way? Just maybe talk a little bit about that flexibility.
Sure, Ann, it's Brian. That I'd say falls into the overall approach of how we approach bringing capital, these type of investment opportunities, and what we think is actually one of the great advantages of having the listed funds and the private funds and having BAM with a strong balance sheet as well. I think what you're getting at, and just to clarify for other folks on the call, is that our listed partnerships, our listed funds, like the BIP and the Brookfield Infrastructure Partners, Brookfield Renewable Partners, are what we describe as cornerstone investors in our flagship private funds. They would have a 20%-30% ownership interest, partnership interest in those funds. When the funds are calling for capital to fund a new investment, then the listed issuer would put up its share.
The funds are organized such that we have multiple sources of capital. If it's a large transaction within a private fund that may be larger than its mandate, it also has the ability to go out and seek co-investors with our institutional partners. That's one alternative avenue of capital. Second, the listed partnership can act as a co-investor and has the ability to put in additional funds. They organize their affairs as investment-grade issuers with diverse access to capital, whether it's through the bond market, equity issue, sale of mature assets, and you've seen us doing that as well.
There are multiple sources of capital for those entities. Finally, we do have Brookfield Asset Management and our balance sheet at the parent level to be able to act as a co-investor or backstop commitments in respect of a larger transaction. We do think we have access to multiple sources of capital that enable us to proceed with some of these larger transactions, many of them at the same time with full flexibility.
Thanks, Brian. I appreciate the color. The other question I had was around the energy marketing business. Wondering if you could remind us what the weighted average life is on those purchase agreements with counterparts, and whether there are any meaningful expirations coming up. Also, what's the remaining life on the contract term with that?
Most of the contracts that we have from BEM, facing the market, what we would describe, they really fall into two camps. There are ones that are very quite short-dated, and those really fall into just how we deal with the power that is not sold under the long-term contracts, which I think are really the contracts that you're asking about. Those have a very long life. There's a couple of smaller ones that are coming due over the next five years, but most of them are very long life and have renewable options. We're talking about an average lifespan of more than 10 years.
Okay, great. Thanks.
The next question is from William Katz of Citigroup. Please go ahead.
Okay. Thank you very much. I'd also like to go back to your letter as well this morning. All that's very helpful. Thank you for all that perspective. You mentioned a couple things in there I'd like maybe you expand a little bit on. One is you had mentioned the wealth management business. I think you said you started a feeder fund. Wonder if you could talk a little bit about strategically, how you sort of think about the opportunity set there. Then on the renewable infrastructure side, I think you also said that you expect that to be a pretty sizable fund as well. How are you thinking about pacing to sort of get to that kind of level of AUM?
With respect to the feeder funds, maybe just to explain what they are, is for smaller investors that don't have the size to invest into our actual private funds. For people that aren't buying in the common market, buying our partnerships, we have private products now that are a combination of a number of our different funds. We offer that as a product. We've just started it. We think it'll be a successful product, it's early days in building a product to match an investor's needs in the private market. With respect to renewables, I do think it's a very large business long scale. It's on the right side of the carbon equation. It's green, the world is going there over the next 50 years.
Therefore, we think that the renewable funds we have will be able to scale up. Probably in the future, we will have separate renewable funds from infrastructure. We think that can be a very large business, either within both renewable and infrastructure together, but also some portions of both possibly separate.
Okay. Just one follow-up. Thanks for taking the questions. Within, you put a fair amount of money to work in the second quarter. I'm assuming all that sort of settled relative to your metrics in June. As you think about where you are prospectively with the private equity book, any way you sort of think through how quickly you might hit the threshold where you could actually get out there and start marketing the successor fund on the private equity side?
Yeah. Hi, it's Brian. It really depends on the rate at which we invest the funds. Once we get up to that 70%-80% of current investment, we are in a position to go out and raise and market a successor fund. We can't be definitive in terms of when we will do that. I think that's the kind of timing. As you see, we've got a pretty good pace of investing going there. We would hope to be out there in a decent amount of time.
All right. Thank you.
The next question is from Andrew Kuske of Credit Suisse. Please go ahead.
Thank you. Good morning. I guess the first question is just along the lines of the product category that you're seeing the most success in selling or turning around the other way, the most inbounds from clients on just from a product category standpoint. What's the most interesting to people?
I think if I understand the question, just with respect to all our products, what are people most interested in? Would that be fair?
Yes
to characterize it? Yeah. I would say that there's an enormous amount of institutional investors that like investing into real estate. Infrastructure only started 10 years ago, but today there's a big thrust into it. Probably the biggest increase on allocations to any sector between infrastructure of real assets being private equity infrastructure or real estate is infrastructure, but merely because it started at the lowest level. The increases and the new clients coming into it
are greater every day. That's merely because the base is lower. Therefore, the allocations. There aren't as many managers. It's not as established, and it continues to grow. I would say there's large amounts of money going into private equity funds, large infrastructure, and large into real estate. They're all quite significant.
Maybe just a follow-up. Is there any inherent contradiction in just the demand that you're having in certain funds and just your fundamental reality of your contrarian investors? Does that create an inherent conflict or an inherent contradiction that you have tremendous, say, inflows in one category, but you like to contrarian invest?
As you know, the reason, and we tried to articulate this before, and I'll try to simplify it. The reason that we set up the business we have, which is in a number of businesses, and it's very global, is because countries don't generally come into favor and out of favor at the same time. Sometimes there's a general economic trend across the world that's positive or negative. Even within that environment, there are situations where it gets much worse. The reason why most of our funds are very global in nature is because we want to be able to capitalize on the situation where we can move the capital and the resources we have to the countries which require capital, and that we can then capitalize on the opportunities with our local people.
To date, I would just say that we haven't had a problem putting money to work in the things that we do on a value basis because we've been able to move from country to country. We'll have to see longer term as the business continues to scale up.
Okay. That's great. Thank you.
The next question is from Neil Downey of RBC Capital Markets. Please go ahead.
Thank you. Good morning. On the subject of perpetual core private funds, if we take real estate as an example, how should we think about one of these funds relative to, let's say, a private REIT in terms of structure, risk, expected return, et cetera?
The way we think of it is really we have three buckets of capital, then I'll come to your private REIT concept. Just to maybe lay the terms out. We think of opportunistic money, we think of our partnership money, then core plus money. The return thresholds go down. The opportunistic money that we're investing is 20% or around there, above or below. Our partnerships are 12%-15% long-term IRRs, and our core plus are 8%-10%-11%, depending on jurisdiction. There's the threshold of returns that we invest across the spectrum of money. I think when you say a private REIT, what you mean is the market in the U.S., where people are marketing private products to smaller investors under the private REIT format. I would say our products are largely institutional.
It takes a lot of distribution to do private REITs, and we don't have that today, and we haven't focused on it, but it's possible in the future we look at it. I'd say they're similar in nature to the core plus returns.
Okay, thank you. The follow-up question maybe for Bruce, maybe better for Brian. I suspect you saw a Wall Street Journal article earlier this week that was entitled "Brookfield's Toll Road to Riches." In that article, the journalist focused on a couple of infrastructure investments, Arteris and I believe Natural Gas Pipeline Company of America. In the article, it referred to how, quote, "Your valuations were at odds with some others on the same asset." I think it also went on to discuss the implications or the author's view of the implications of these valuations on your asset management fees, whether it be for the listed issuers or the private funds. Could you maybe just comment on some of the content of that article?
Sure. Neil. It's Brian. Thanks. That's a rehash of a story that you may have noticed ran a while back in Barron's, and it does contain a number of fundamental inaccuracies. In particular, we felt it was misleading. As you noted, there's the suggestion that our use of fair value accounting can lead to some questionable increases in book values, and that in turn can result in higher management fees payable to Brookfield, and that's simply not the case. As you can imagine, this is something we take very seriously. I would say a couple of things. Most of you on the call will know this already, but this is important. First of all, the management fees that Brookfield earns are based on the stock market capitalization of our listed affiliates and not based on the IFRS valuations or book values.
In fact, if you look at the company that owns those assets that you referred to, Brookfield Infrastructure Partners, most of the assets owned by BIP are not actually marked to market at all because they are concessions. The IFRS value is only a fraction of what the value of the company is. This is further evidenced by the fact that BIP has sold many businesses over the past number of years, proceed significantly above IFRS values. We've observed that when investors look at a company like BIP, they're really looking at the ability of it to increase its cash flows and therefore pay a good dividend, reliable, and one that increases steadily over time. Again, none of this is influenced by the IFRS valuations.
Again, the other point we'd like to make, this comes to your comment on the questions raised about the values of Arteris, which is our Brazilian toll road operations, in particular. The suggesting that we had widely differing values that we applied to it, assigned to it. Again, that's just not true. We did not revalue this asset over that time period. In fact, we don't even use fair value accounting for Arteris. Just to clarify the confusion around that one, the increase in the value of Arteris was due to two factors and two factors only. First, we invested another $700 million of cash in the business, to fund capital projects and purchase minority interest. Second, the exchange rate for the Brazil currency went up by over 20% during the period.
This had nothing to do with our change in our valuation of the business. I hope that helps clarify your question.
Okay. Thank you.
Just a reminder, if any analyst has a question, they may press star then one to join the question queue. The next question is from Mario Saric of Scotiabank. Please go ahead.
Thank you and good morning. I just wanted to come back to the perpetual fund discussion. We're sitting here, it seems like a fairly sizable opportunity. To me, it's akin to perhaps the opportunity that surfaced post Global Financial Crisis in 2009, 2010, when you launched many of your global opportunistic funds. When we sit here today, how do you think about the opportunity going forward in relation to how you thought about the opportunity with respect to launching the opportunistic funds post the Global Financial Crisis? Is there a catalyst that you can see that can drive that type of fee-bearing third-party capital growth under the perpetual funds, similar to what you saw for the opportunistic funds late in the decade?
It's Bruce. I would just say that, firstly, we think there's an opportunity. If interest rates stay relatively low, this opportunity's going to stay for a long period of time. These things never happen overnight. They take a lot of hard work and a lot of getting the franchise to work together. For us, it should be easier than for most because it's just strapping this business onto what we have, we do a lot of this in other areas. Therefore, we should be able to do it. I would say that over the next 5 to 7 to 10 years, as long as we're in a low interest rate environment, this business is going to expand exponentially because it's going to really replace a portion or a significant portion of traditional fixed income investments in pension and other sovereign plans.
We think the opportunity is very big, success will be how we execute over the next 10 years.
Okay. Just maybe on your comment on the fixed income investors kind of driving demand for that product offering. Is the offering complementary to your existing offering in terms of your opportunistic funds? Insofar as the expectation isn't that your ability to raise these $10 billion-$20 billion opportunistic funds in the foreseeable future is in any way compromised by raising substantial perpetual funds?
No, I'd actually make the opposite argument. What we've continued to find is we broaden out, and we continue to bring other products to our clients. It enhances our relationship with them and therefore, enables us to have a better long-term business. We don't think this is. They're a different category. That's why we tried to make the emphasis. One's an equity alternative, one's a fixed income alternative. These are different buckets within a pension plan. The overall relationship we have is enhanced by the greater number of products that we can offer them in a responsible basis. We think longer term, this is all additive to the franchise.
Understood. Okay. One last clarification question from me, and I appreciate it's a longer-term comment, but the $50 billion opportunity that you see in each of real estate, infrastructure, and renewable power in the perpetual side, would that be an equity figure or an asset value figure?
Let's go with asset values for now. How about that?
Okay. That's great. Thank you.
The next question is from William Katz with Citigroup. Please go ahead.
Okay. Thank you for taking my follow-up question. Just sort of coming back to capital management for a moment. Sort of thinking through over the next year or so, looks like you're at a nice pivot point in terms of fee-bearing AUM rising. How are you thinking about maybe buyback versus reinvestment back into the business and/or dividend policy? Thank you.
I'll maybe start and Brian can add to it. I'd just say, firstly, we've had a general policy to have a relatively modest dividend relative to what we could pay in the business, but to increase it over time with increases in cash flow in the business, and we don't really plan on changing that. Point number two, we do generate very significant amounts of excess cash flow and have a highly under-leveraged balance sheet. The only thing I would say is, we always want to have very significant amounts of capital, A, to support all of our funds and all our affiliates if we need it, and B, be prepared for an opportunity should it come along. I guess the point I would say is, at this point in the business cycle where the stock markets are more robust certainly than they were in 2009.
We're probably more apt to continue to put money into our businesses and liquefy our balance sheet and continue to put cash and financial assets on the book, to be prepared to do things either within the business or buying back stock at a different point in time.
Thank you.
It's Brian. The only thing I'd add to that, Bill, is the ability to incubate new fund strategies on our balance sheet directly, just to clarify Bruce's comments.
Understood. Okay, thank you.
This concludes the question and answer session. I would now like to turn the conference back over to Suzanne Fleming for closing remarks.
With that, we'll end the call. Thank you everyone for participating.
This concludes today's conference call. You may disconnect your lines. Thank you for participating, and have a pleasant day.