Buying Blackstone (BX)

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.

Full disclosure: I own both shares and options on BX.

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Is Blackstone Actually Tempting Here?

Everyone -- myself included -- has had their fun ridiculing hedge funds and private equity lately. The implosions of a few relatively high profile funds, the growing awareness of the fact that most hedge funds make their money not on successful investments but on fees (and the investor backlash from that), and the very strong feeling that Steve Schwarzman has played everyone for a fool by taking a small slice of Blackstone public at the top of the market.

But maybe there's a contrarian buy in there, especially now that we see, from the Goldman Sachs earnings, that not everyone loses money when turmoil hits the markets. Goldman and Blackstone are in similar positions reputation-wise, as the top tier of their respective (and related) businesses, and it might be worthwhile to speculate that even in a difficult environment for private equity, which many people foresee, Blackstone could potentially significantly outperform our expectations. And as was announced today, Blackstone's President is claiming (though they haven't reported yet) that they, like Goldman, enjoyed a nice return on short positions in subprime mortgages (and as an aside, that they believe the debt logjam for private equity will be sorted out within six months). It'd be interesting to see just how significant those short positions were, and how much it impacts their bottom line.

I am not yet really convinced, but I'm taking a few things into account as I consider whether a position in Blackstone or in Fortress or one of the similarly exposed firms is worthwhile. Most of my speculation would be based around the "best of breed" argument that even in a relatively poor market the top performers might well continue their performance, so I'm probably not interested in the Listed Private Equity Portfolio ETF (PSP), even though that fund holds some companies I really like, including Leucadia and Affiliated Managers Group.

So what makes me think about possibly throwing some of my cash in with Blackstone?

1. Blackstone has incredibly huge piles of money. Not only do they get to reap nice fees from that money as they invest it, but they also have significant potential to make big investments in firms, even taking them private, without nearly as much leverage as has been used in the past. This might be significant, given the difficulty in getting some debt deals done.

2. It's entirely possible that interest rates will remain low if the Fed decides to further prop up the economy -- in that case, I think we'll see the covenants on private equity financing probably remain a bit stricter than they were in past years, but in all likelihood there will be money chasing these deals again. Nothing lasts forever, but, as many people have speculated, they may have refilled the punch bowl just one more time.

3. There are still plenty of opportunities to buy cheap companies around the world, and Blackstone's massive size, which enables them to have fingers in pies in every section of the globe, should benefit them. Not the least of the appeal here is the Chinese interest in Blackstone, which should give them a bit of an entree to that market.

4. High yielding stocks should be incredibly appealing if interest rates fall. Blackstone, as a partnership, has every potential for spitting out significant dividends. The risk, as I see it, is that shareholders might be taxed on distributed income that's not necessarily actually distributed in cash.

5. A severe shakeup in private equity and hedge funds, perhaps resulting in more attention paid to fees and to a closer eye taken by institutional investors, might actually be GOOD for Blackstone. The massive proliferation of hedge funds and private equity funds has brought competition to their marketplace, the implosion of the weaker funds among those might make for a more orderly environment and for fewer bidding wars for choice assets.

and 6. If the analysts are anywhere near correct, the shares trade at around a market multiple going forward ... and I would imagine that Blackstone, being financially savvy folks, are focused on finding ways to outperform analyst targets. They trade at a substantial premium to the big brokers and diversified financials, of course, but quite in line with the large asset managers like Legg Mason and at a significant discount to T. Rowe Price or Franklin Resources ... to say nothing of the really rich comparative valuation for Blackrock, which must chap the folks at Blackstone quite a bit given their history with the similarly named firm.

So that's what I'm thinking so far ... maybe we're giving Blackstone too much credit when we say they sold shares at the top of the market. Even in a weaker private equity environment the strongest players should still have plenty of business -- there will always be demand for private investments and for excellent asset managers who can cater to the pension funds that are truly desperate for outsize returns as the baby boomers begin their retirement years.

The risks?

1. Taxes. I would argue that part of the weakness in BX shares is the fear of increased taxes on partnership income/carried interest/etc., so perhaps some of that is baked into the shares. I certainly have no idea, even though the White House is a mere five miles from my house, what will happen there.

2. Fee erosion. It's possible that the attention paid to fees will lead to private equity and hedge funds competing on fees, smashing the 2/20 golden egg. I'm inclined to believe that institutional investors have no problem paying these fees FOR PERFORMANCE, but I do think that lower performing funds will see significant rebellion.

3. Exit strategy. For private equity investors who are depending on exiting their positions by re-IPOing their leveraged buyout targets, the market sentiment at the time they're ready for the IPO will of course be of paramount performance. I have no way of predicting that, and I won't try ... suffice to say, if they can't sell the companies they own, they may have to serve peanut butter and jelly sandwiches in the executive cafeteria for a few weeks.

If Blackstone can remain among the top performers, I see no reason why they won't be able to continue to charge ridiculous fees -- the investors who migrate to them want the outsize returns and some market neutral return, and they believe in the power of excellent management ... they are not likely to become index investors overnight, especially with the increasing demands on pension funds to fund ever larger groups of retirees in the years ahead.

Other than that, the standard risks of competition, a general collapse in the economy, or personal or corporate scandal are always there, for nearly any investment, but I don't think they're outsize risks for this particular company.

As I said, I'm undecided ... I'm interested enough that I'm looking right now at a small position in Blackstone options, but I need to research further if I'm to consider really opening a stock position here and committing more capital. The shares seem to be in a bit of a recovery here over the last week or so, after bottoming out in the low 20s during the worst of the August swoon.

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