November 20, 2007

On Blackstone

Steve Schwarzman spoke at the Merrill Lynch conference today, and I think some of what he said about his company, Blackstone, has been overlooked in the wash of John Thain rumors. I picked up a few shares of Blackstone today.

So what did he say that was interesting?

About the business:

He said that the alternative assset industry is a "marvelous place."

And that risk-adjusted returns are way above returns from traditional assets.

Importantly, he noted that institutional penetration is still low -- most big institutional pension plans have only 4 or 5% in alternative investments, and they are looking to increase that allocation.

(Personally, I think this increase in market share for private equity and alternative investments is a huge opportunity for Blackstone -- pension fund managers are going to be in a near panic to hit their numbers as the baby boomers retire, and they'll look longingly at the outsize returns achieved by David Swensen at Yale using allocations of more like 20-30% in various alternative assets like private equity, hedge funds, and real estate ... all areas of significant Blackstone strength).

Schwarzman also opined that Blackstone has been given a significantly lower multiple than traditional money managers, but has more than three times their growth rate.

Beyond that, he took a bit of a stab at the analysts who track the shares and noted that "We are not focused on quarters, we are focused on building value for the long term" -- which of course is something many people say, and I don't know whether Schwarzman is more or less believable in saying that than anyone else. They don't give quarterly earnings guidance, which is certainly one indication that they really believe this.

I like that management and employees are incentivized by the distributions and performance of the Limited Partnership Units. The existing partners, according to Schwarzman, are pushed out to an 8-year vesting schedule, significantly longer than average, which means they will be sitting on big embedded costs over the years that they vest these shares and that those people are very motivated to stick around -- the IPO wasn't a one-day gravy train for them. Those costs of vesting options are what surprised investors a little bit with the high costs during their last earnings release, but of course they have nothing to do with operating earnings.

Blackstone has separately stated that they more or less promise to have an ongoing distribution of 1.20 per year as a minimum through 2009 (close to a 5% yield), and Schwarzman reiterated that they will continue to distribute additional income as they make more. As befits a partnership, the reason for their existence is to funnel excess cash earnings to unitholders.

But what stood out for me in his comments was his hypothetical projection of Blackstone performance -- and of course, since they don't really give guidance this wasn't official guidance, but it was dramatically optimistic in comparison with current results. That specific kind of optimism is somewhat rare from CEOs in these post-SarbOx days, and it makes me wonder whether analysts really are lowballing Blackstone's long term potential right now.

Schwarzman said that the two keys for them will be the size of assets under management, and the rate of return on those assets. That's because they essentially make their money from the management fee, which is charged regardless of their performance, and the carried interest return, which is the percentage of gains that they charge.

Returns have historically been massive in comparison to the overall market, but also quite lumpy -- I think that if they can keep getting their average returns their income should be remarkable. (It's worth noting that many people consider the last five years to have been the "golden era" for private equity, and that those returns might be impossible in the future.)

So it's important to note that Blackstone is still raising record amounts of money, and still finding ways to invest it. Schwarzman said that "People fundamentally missed that we committed to invest 6.9 billion dollars in one quarter in private equity and real estate." That's $6.9 billion that they can start charging fees on.

If they have many future quarters like that, Shwarzman said that from just that one part of their business they could "theoretically make $8 billion in profit in a year."

And as part of that same hypothetical exercise, "estimates that show earnings in the $1-2 billion range could prove to be dramatically wrong."

I don't want to overstate this -- and Schwarzman tried to be quite politic about it, too, in emphasizing that the $8 billion potential assumes that everything goes their way, they get returns in line with their average, and they continue to attract a lot of money. But I am a little surprised at the lack of attention it got -- there was one Reuters story titled "Blackstone CEO sees earnings estimates way too low," but that was all I saw. You can, of course, listen to his presentation yourself if you like through the IR section of the Blackstone website.

They of course can't control their circumstances entirely, but clearly Schwarzman believes that there is potential for really dramatic outsize returns because of the power of carried interest and the massive amounts of money that the world is willing to give Blackstone to invest.

So, the overhangs on Blackstone (and all other private equity firms, at least the public ones) remain -- lumpy earnings, a business that the analysts are going to have a really hard time projecting, and the threat of higher taxation on carried interest (which seems to me to be largely baked in to the stock at the current forward PE ratio of around 13), to say nothing of the possibility that tighter debt terms and higher interest rates might hurt the potential for really massive deals in the near future (though I think Blackstone has said that their average deal is a relatively modest $500 million, which certainly doesn't require massive debt financing when you're talking about investment funds of $20 billion or more).

This seems like a bit of a contrarian buy, as does anything financial these days, but I think the asset managers in general are going to be excellent investments over the next ten years, and as the leading light in a segment of that business that's well positioned to take market share from competitors, especially among the big pension managers that are the engine of private equity funding, I expect very good things from Blackstone over the long run ... and I think the downside is limited if performance of the company remains just average, especially in the near term with the backstop of that 5% dividend.

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