The Value of Blackstone's Business -- Part Two

This article was originally written in May 2007, prior to Blackstone's IPO on 22 June.

Part one of our series on buyout firm extraordinaire The Blackstone Group focused on key drivers of its business. Here, we'll take a look at what investors need to look out for going forward.

For those unfamiliar, Blackstone has quite literally made a fortune by running various private equity and hedge funds on behalf of its predominately institutional clientele. Blackstone's prodigious growth and the elan with which it has landed deal after deal--the next one seemingly splashier than the last--have made it one of the most closely watched boutiques in the financial world.

Now that Blackstone management has taken the wraps off of its plans to sell a portion of the firm in an initial public offering, a number of questions have arisen. Among them, what does an investment in Blackstone shares buy an investor? How has the firm made money in the past? What has driven its meteoric growth? Are those trends sustainable? And, the merits of the business notwithstanding, what's a fair price to pay for the firm?

In our first piece, we tackled a few of those questions, establishing the sources of Blackstone's outsized revenues and profits and examining some of the attributes that make the firm's business model so breathtakingly attractive. Put simply, Blackstone has practically minted money in the past.

Yet, what about competition? And are there any rules of thumb or benchmarks that investors should consider in trying to put a price on the shares? We take a whack at those questions below.

Binge and Purge?
Staggering profitability tends to beget competition, partly explaining the meteoric growth of the alternative investment management business, which now teems with thousands of hedge fund and private equity managers.

Yet, Blackstone's success is no fluke. The firm boasts generally strong performance across its funds. That record has kept it in good stead with existing investors, engendering loyalty in the process (per the firm's filing, investors representing roughly 87% of capital in the firm's private equity, real estate opportunity, and mezzanine funds have invested in successive funds in the same category). It's also likely to stimulate continued demand for the firm's products, which should more than counteract the natural attrition that can occur when a given private equity fund is liquidated at the end of its contractual life. As if to underscore that point, Blackstone won more than $17 billion in capital commitments for Blackstone Capital Partners V in 2005, making the corporate private equity fund the largest ever raised. (The firm is reportedly in the process of raising commitments for another $20 billion private equity fund.)

Nevertheless, strong performance can prove fleeting, even for Blackstone. For instance, if Blackstone's funds were to go into a prolonged funk, once-loyal investors would likely head for the exits (that is, once they freed themselves of the legal entanglements and switching costs previously mentioned) while prospects would maintain a safe distance.

Then again, Blackstone's asset base is reasonably well diversified across product types, as it spans private equity funds, real estate opportunity funds, proprietary hedge funds, and funds of hedge funds. Further, while Blackstone has demonstrated a faculty in contrarian-minded investing, it hasn't pigeonholed itself into a particular investing style. This too should help to weatherproof the firm.

More fundamentally, Blackstone boasts an attribute that's increasingly coveted in the institutional world--scale. In short, institutions that are wading into the hedge fund and private equity arena are looking for signs of staying power and risk-management acumen, traits often denoted by the sheer size of a firm. With $78 billion in assets under management as of March 2007, Blackstone stands as one of the largest alternative investment managers in the world, an attribute that's likely to keep it on the radar of many an institutional investor going forward.

In addition, with institutions and private equity firms increasingly setting their sights on larger prey--a trend exemplified by a private equity consortium's recent announcement that it was taking student lender Sallie Mae private in a leveraged buyout--Blackstone should find itself in the catbird seat, as smaller firms will be unable to match its sheer fund-raising ability. That likelihood is likely to spur further interest from institutions hoping to get a piece of the next mega-fund.

Buyer Beware
Merits of the business notwithstanding, you're going to want to pay a fair price. And if the recent past is any indication, this is one offering you'll probably want to sit-out.

The "past" we're referring to is Fortress Investment Group, which made its much-ballyhooed debut in February 2007 and promptly soared 68% on the first day of trading amid heavy investor demand for the shares. Though the stock has since retraced some of its initial gains, it recently sported an $11.5 billion market cap, putting the company on par with well-known U.S. asset managers T. Rowe Price Group and Legg Mason.

What's most striking is the fact that Fortress, while successful and handsomely profitable in its own right, is a fraction of T. Rowe and Legg's size when measured by assets under management. At recent levels, Fortress was trading at a heretofore unheard of 33% of assets under management. In stark contrast, Legg Mason was recently commanding a mere 1.4% of assets under management while T. Rowe garnered a slightly less meager 3.7%. (Though an approximation, the benchmark that we typically use when evaluating asset manager acquisition prices is 2% to 3% of assets under management.)

Yes, there are noteworthy differences between traditional and alternative asset managers that could explain such a disparity. For instance, the composite fee rate on hedge fund and private equity assets is far higher than that on traditional strategies. To wit, a hedge fund levying a 1.50% management fee and a 25% incentive fee (with no hurdle) stands to earn 3.13% of assets under management when the fund returns 8% before fees. Compare that with T. Rowe, whose $1.5 billion in investment advisery revenues in fiscal 2006 was equivalent to 0.50% of average assets under management.

In addition, hedge fund and private equity assets are also likely to be stickier than those of traditional managers for the reasons previously noted, which makes them more valuable. Finally, provided that the ownership structure is sufficiently Byzantine in nature, it's possible that a given alternative asset manager is taxed as a partnership, rather than as a corporation. That's true of Fortress, the income of which is taxed at very low marginal rates. The same can not be said of most traditional asset managers that we cover.

Nevertheless, these differences aren't sufficient, in our opinion, to close the yawning gap that separates Fortress from the traditional asset managers that we cover. While we don't evaluate companies based exclusively on relative measures of value, it shouldn't come as a big surprise that our fair value estimate for Fortress--which we derive by discounting the company's projected future cash flows to the present--is well below the stock's recent price.

Blackstone: Good Business, Bad Price?
Which brings us to Blackstone. While the firm and its underwriters have yet to price the shares being offered, it stands to reason that the stock is going to be a particularly hot issue. Blackstone intends to sell 10% of the firm in exchange for $4 billion, which implies a $40 billion market cap (Editor's note: The Blackstone Group came public at US $31 per share on 22 June, and soared as much as 17% in early aftermarket trading). To put that number in perspective, Blackstone stands to become not only the largest U.S. asset manager by market capitalisation, exceeding even Franklin Resources (which was recently managing nearly $600 billion in assets), but also one of the largest financial services firms, period.

In a sense, this is a tribute to the work that Blackstone management has done to burnish the firm's reputation in the marketplace. More cynically, the timing of the offering can also be viewed as another testament to management's shrewd business instincts. Apart from Fortress, there are no other pure-play U.S.-listed alternative asset managers. Thus, an offering gives Blackstone the chance to tap into the market's pent-up demand to get a piece of the hedge fund action. Further, it allows management to cash in some of its chips at what, by any reasonable standard, is likely to be a very frothy earnings multiple.

Thus, while there are perfectly legitimate business reasons for Blackstone to pursue a public offering--not least of which is giving the firm a permanent, flexible funding source, in addition to private investor capital and commercial debt financing--we think that investors should make caution the better part of valor in valuing the shares.

With that in mind, investors would be well served to consider what are likely to be Blackstone's enduring competitive advantages and how those advantages might translate to economic value in the future. To that end, we've ticked off a short list of the attributes--the firm's recognisable brand, scale, strong investment record, and switching costs. We hope it will prove a useful starting point for your own research.

Blackstone is a great business. But even the best can be bum investments at the wrong price.