Thursday, November 20, 2014

Blackstone Proposes a Product that Benefits Blackstone

Blackstone Proposes a Product that Benefits Blackstone

Blackstone Group is looking for five or six investors willing to invest about $2 billion apiece into “core” private equity.  It’s not clear what “core” actually means, and I am sure the legal documents will eventually give Blackstone a great deal of latitude over the definition.  I think the concept is being borrowed from private real estate funds, where “core” means investing in properties that are usually close to fully leased with little development risk.  In the case of private equity, Blackstone is trying to distinguish between conventional PE and the new concept.

Blackstone’s latest product idea is designed to attract and lock up more permanent capital, which might afford Blackstone a higher valuation in the public markets.  At present Blackstone must continuously market new funds, because a conventional 10-year fund is usually fully invested within about 3-4 years, and the bulk of investments are usually sold within 6-8 years.

According to press reports, the fund would invest in less risky companies than a conventional buy-out fund and use less leverage.  The idea might have the following kinds of terms (conventional terms in parentheses):

            Life of the fund: 20 years  (10 years)
            Management fee: 1.5%  (2%)
            Carried interest: 15% (20%)
            Capital Invested: 100%  (65%)
            Hurdle Rate: (< standard 8%)
            Target Return: 12%  (20%)

To be sure there are aspects of Blackstone’s pitch that might be attractive to large institutional investors.  A fund with a longer life and less turnover would enable an investor’s capital to compound more efficiently because their capital would remain invested.  In addition, since companies would be held for longer periods of time, investors would incur fewer transactions costs.  I’m sure there are plenty of investors who will be wooed by the promise of lower fees.

However, Blackstone’s pitch requires investors to tie up their money in an illiquid vehicle for the better part of two decades.  Should a pension plan or sovereign wealth fund make that kind of long-term bet with a PE firm that is likely to undergo massive changes over two decades?  Does 12% offer investors a big enough liquidity premium for such a long-lived private investment?  Will the monitoring and board fees imposed on the portfolio companies more than offset any discount in the management fees?  Will a lower hurdle rate more than compensate Blackstone for reduced carry?  Obviously, we’d need the details of Blackstone’s proposal to definitively answer these questions.  Based on back of the envelope calculations, I’m pretty sure, that Blackstone comes out ahead of its investors on this type of product offering.

 find two aspects of Blackstone’s pitch rather revealing.  First, it is quite an indictment of the conventional PE product.   Blackstone is basically saying to some of its largest investors that the conventional PE fund doesn’t do a very good job of putting capital to work.  Moreover, they are as much as admitting that the 20% return of a successful PE fund is overstated.  Return is calculated using the internal rate of return method (IRR), which is the best approximation we have when an investment has irregular cash flows.  Nonetheless, IRR is deeply flawed and very often overstates the returns achieved by a PE fund (see, “Another Quick Lesson in Private Equity: All Returns Aren’t Created Equal [November 16, 2012] for a detailed discussion of the flaws)”.  I also think it takes a bit of nerve to ask investors to accept a lower hurdle rate.  For those that don’t dabble in PE funds, the hurdle rate is the amount a fund must first earn before the manager begins to share in carried interest.  For example, if a fund has an 8% hurdle rate, investors get this “preferred return” before carried interest (profit sharing kicks in).

Second, if large institutional investors are looking for and willing to take the risk of a 12% return, there’s a much less expensive solution.  A pension can borrow at considerably lower cost than private equity, so it could replicate Blackstone’s proposal by issuing its own debt and then investing its capital in a low cost ETF or perhaps Warren Buffet’s company.  Over 20-years, the simple formula would at least match Blackstone’s core PE strategy without tying up the pension’s capital.

Blackstone has $284 billion in assets under management.  In order to keeps its shareholders and senior executives (who are also major shareholders) happy, they are going to need to find major new markets. Core private equity is just another marketing strategy.

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