June 22, 2017 / 6:33 PM / 2 months ago

Blackstone may have to financially engineer itself

NEW YORK (Reuters Breakingviews) - In a sense, Blackstone is back where it started. On June 22, 2007, at what turned out to be a market peak, Steve Schwarzman and Pete Peterson took their private-equity firm public in a ballyhooed transaction that inspired rivals to do the same. A decade on, the firm's units are trading only just above the $31 price where they sold ahead of their New York Stock Exchange debut. A better result over the next 10 years could require Blackstone to financially re-engineer itself.

Even including dividends, assumed reinvested to derive a total return, Blackstone's performance has been just ordinary. At about 7 percent a year since the initial public offering, its stock has fared no better than the S&P 500 Index, and at a much higher risk. The roughly $360 billion the firm has to deploy into buyouts, real estate and credit on behalf of pension and sovereign wealth funds historically has generated at least twice as much return for the investors in the funds Blackstone runs.

And while Blackstone units have outperformed the 1.2 percent total return delivered by shares of Wall Street blue chip Goldman Sachs, they've badly lagged some best-of-breed money managers, including BlackRock, the mutual and exchange-traded fund behemoth, and Berkshire Hathaway. Warren Buffett's conglomerate makes for an apt comparison in that it's an investment akin to owning a slice of both Blackstone's publicly traded units and a piece of each of the companies held by its funds. (Breakingviews graphic: Blackstone total returns since IPO: tmsnrt.rs/2sZzjBZ)

PUBLIC GOOD?

Inside 32-year-old Blackstone, the stock performance isn't the main measure of the IPO's success. Simply going public conferred a certain brand status, particularly overseas. Selling a big slug of the new units to China Investment Corp also paid off. The early investor gritted its teeth through a share-price decline of nearly 90 percent at one stage and helped Blackstone forge relationships with other pools of capital in the People's Republic. Over the years, the firm has sold more than $30 billion of its holdings, including stakes in Hilton Worldwide and European warehouse owner Logicor, to Chinese buyers. And Schwarzman established a unique scholarship program at Tsinghua University.

The units also provided a currency to reward employees and to grow the firm. For example, less than a year after the listing, Blackstone used units to help fund the acquisition of GSO Capital Partners, which significantly enlarged its credit-investment arm. Since going public, Blackstone has quadrupled its assets under management while growing its workforce by less than three times, to about 2,100.

That's a measure of the economies of scale Schwarzman and his right-hand man, Tony James, have produced, with the right people to help them. They're not alone, though. Over the same span, Larry Fink's far larger BlackRock has nearly quintupled the amount it oversees, to some $5.1 trillion, with two-and-a-half times the staff, now numbering 13,000.

Opening its books to public scrutiny also may have made it easier for Blackstone to get a credit rating. That in turn has allowed it to borrow, but also to encourage incoming fund investors with an extra demonstration of its financial robustness.

Stephen Schwarzman, Chairman, CEO and Co-Founder of Blackstone, speaks during the Milken Institute Global Conference in Beverly Hills, California, U.S., May 2, 2017.Lucy Nicholson

MISUNDERSTOOD

Nevertheless, it is the stock-market perceptions of Blackstone that perplex Schwarzman, who routinely gripes about them. Merely putting its profit on the broad average price-to-earnings multiple would make it a roughly $50 stock, he recently argued. If instead of its recent dividend yield of about 8 percent the units were priced on the S&P 500 average payout of a little over 2 percent, they'd fetch over $100 apiece, he claimed. With Blackstone's current market capitalization at about $40 billion, that would represent a huge markup for investors.

Despite years of attempting to educate outside investors, and the subsequent IPOs of rivals such as Apollo, Carlyle and KKR, portfolio managers are reticent to ascribe much value to private equity's secret sauce, which is generating profit on investments and collecting a cut. Instead, it is steady management fees of 1 percent to 2 percent on assets that are coveted.

This attitude favors investment managers who worry more about gathering assets than making money for those who invest in them. Blackstone did say from the start that its main goal would be making money for limited partners in its funds, a group which includes its own senior people, rather than for investors in the firm's publicly traded units. The trouble is that when the profit does flow through to unit holders, they don't value it as highly as they might.

A NEW DECADE

Such an unchanging mindset suggests that if Blackstone is genuinely keen to see its stock rise more strongly in the next decade, it may take more than Schwarzman thumping the table. One option could be to pay a fixed annual dividend rather than a variable one based on performance. It's a solution that could perversely mean giving back less to unit holders than the firm has of late, but it might help assuage investor fears about the lumpiness of returns.

Any excess funds stockpiled also could be used to buy back units, thus enabling Blackstone, in theory at least, to goose their price. One case study is not encouraging so far, though. KKR unveiled such a plan in October 2015 and has not benefited much in terms of its stock price.

An even bigger Blackstone makeover might have a greater effect. Converting the firm from a partnership to a more conventional sort of corporation would garner considerable attention. For one thing, it would make its stock eligible for entry into indexes, thus attracting many forced, index-following buyers. Investors who are currently put off by the firm's complex partnership structure and paperwork might consider putting their money into a simpler Blackstone that has shares, not units, and pays regular corporate taxes rather than passing untaxed income through to unit holders.

Such a radical restructuring, though, could require a reduction in U.S. business tax rates to make it financially worthwhile. In one of his other roles, Schwarzman is serving as a consigliere to President Donald Trump, who says he is eager to cut taxes. The association may provide a modest advantage. More likely, though, is that Blackstone and its leadership team will have to find one for themselves.

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