Plus: Archegos, US Payments, Monzo, Finally
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Asset management is a big topic of focus for us here at Net Interest. Over the months, we’ve tackled the industry from several angles:
In Zuckerman’s Curse, we looked at the economics of hedge funds and why their returns tend to drop off when they get bigger;
In The Private Equity Firms’ Private Equity Firm, we explored the origins of the private equity business model and the differences between owning an investment management firm and being a client of one.
In Other People’s Money, we examined the quest for permanent capital pioneered by Warren Buffett and increasingly being copied by present-day investment management firms.
Along the way, we’ve touched on many firms: Sculptor, Renaissance, Paulson, Blue Owl, KKR, Berkshire Hathaway, Markel, Bluecrest, Nomad and more. But we haven’t gone into any one of those companies deep.
This week we seek to redress that with an exploration of Blackstone.
Blackstone is the largest alternative asset manager in the world, which means it traffics in the kinds of investments that don’t fall into the conventional buckets of stocks, bonds and cash. There are around $250 trillion of securities in conventional stock and bond markets around the world; Blackstone is focused on the $14 trillion market of investable assets that sits outside them. It currently manages in excess of $650 billion of assets and targets a trillion.
Last week, it overtook Goldman Sachs in market cap, making it one of the largest financial institutions in America. But for many investors it’s still an enigma. In this briefing, we look at:
The economics of private equity
Blackstone’s expansion into real estate and beyond
How Blackstone makes money
Blackstone’s secret sauce
Blackstone’s roots lie in a two-person start-up founded 35 years ago in New York. This wasn’t your usual scrappy startup – its founders had pedigree. In October 1985, Stephen Schwarzman, a former head of global M&A at Lehman, and Peter Peterson, former Chairman and CEO of Lehman (and before that Richard Nixon’s Secretary of Commerce), established Blackstone as a private investment banking firm. Peterson had been ousted from Lehman a year or so earlier in a power struggle with the bank’s chief trader. Soon after, the firm ran into trouble in the European commercial paper market and Schwarzman was tasked with selling it. He did a deal with his next-door neighbour in the Hamptons and Lehman was sold to American Express. Schwarzman hung around for a bit but he knew he wanted out and began breakfasting with Peterson to brainstorm business ideas.
Although his business was M&A, Schwarzman had his eye on the burgeoning leveraged buyout (LBO) market. He’d been introduced to the market in the early 80s as an advisor on some high profile LBOs. The premise was simple: buy a company by putting up some equity and borrowing the rest. The company pays interest on the borrowed piece from its own cash flow; meanwhile, the investor improves the operating performance of the company with a view to selling it for a gain.
Schwarzman recognised that the LBO business was more scalable than the M&A business. “As M&A bankers, we would be running only a service business dependent on fees. As investors, we would have a much greater share in the financial upside of our work.” At Lehman, doing both was viewed as a conflict of interest; at his own firm, that could be managed.
“The appeal of the private equity business model to a couple of entrepreneurs was that you could get to significant scale with far fewer people than you would need if you were running a purely service business… Compared to most other businesses on Wall Street, private equity firms were simpler in structure, and the financial rewards were concentrated in fewer hands. But you needed skill and information to make this model work. I believed we had both and could acquire more.”
In order to fund their LBOs, Schwarzman and Peterson needed to raise some money, so after a year or so of focusing exclusively on M&A, they hit the streets to raise their first fund. Anyone who has marketed a fund before will be familiar with the struggles they faced. Despite their reputations, they didn’t have a track record to boast and so prospective investors resorted to the age-old heuristic – social proof – to determine whether to invest. A fund is an interesting social structure: investors are much more comfortable participating if other investors are involved. In Blackstone’s case, a ticket from Nikko in Japan was the anchor to raise 2.5x that amount from other Japanese investors and a ticket from GE flushed out other investors in the US. Some investors were more explicit. MetLife came into the fund early but on condition that Blackstone could raise 10x that commitment from other investors.
In total, Schwarzman and Peterson met 488 prospective investors; 33 invested (MIT isn’t the only allocator to pass on most of the emerging managers it sees). On 15 October 1987, they closed their first fund with $850 million of commitments. The following Monday the stock market crashed. Blackstone’s history is grounded in some lucky market timing.
The Economics of Private Equity
Blackstone’s first LBO was of the transport division of USX, which it renamed Transtar. It paid $650 million for 51% of the business, putting in just $13.4 million in equity (USX put in $125 million in vendor financing and Chemical Bank lent the rest). Within two years, Blackstone had made a 4x return on its investment and by the time the last piece of equity was sold sixteen years later, the return was 26x.
Similar deals followed over the next six years. When that first fund (Blackstone Capital Partners I) was finally liquidated, it had returned 2.6x to its investors before fees. Blackstone took out a quarterly management fee along the way, of 1-2% of capital commitments during those six years and at least 0.75% afterwards. But most of its payoff came at the back end, on the exit of an investment, when Blackstone took a 20% cut of the realized gain after any preferred annual return investors were eligible for. Schwarzman likens the revenue model to farming:
“…We’re like farmers. When we buy companies and real estate, it’s like planting crops. You put seeds in the ground, you water, and the seeds start growing, but you can’t see the crop yet. Then they grow very high, and it will be a great crop, and you will be very, very happy.”
The 20% cut meant that that first fund yielded around $250 million for Blackstone and its handful of partners – a scalable business indeed.
Since that first fund, Blackstone has raised fifteen more funds in corporate private equity as well as others focused on specific niches like secondaries (where it acquires interests in existing funds), growth equity, infrastructure and life sciences. It currently has $66 billion ‘in the ground’ in private equity and $63 billion of ‘dry powder’. Through its funds, Blackstone owns around 250 companies, employing more than 500,000 people. Each quarter, the valuations of these companies are marked to market based on their underlying operating performance, but it’s not until exit that Blackstone captures the value. In the past twelve months, valuations in corporate private equity are up 52%. Accrued performance fees that could be crystallised on a realisation event are up to $3.6 billion, but if all of those funds in the ground plus the dry powder can be invested at a 2.5x return, then the total payout could be more than ten times that.
Blackstone’s Expansion into Real Estate and Beyond
In the early 1990s, Schwarzman became attracted to real estate. The real estate crisis at the time left many assets at distressed valuations and Blackstone decided to try its hand. In partnership with Goldman Sachs, it bid on a portfolio of garden apartments in Arkansas and East Texas at a government auction. But the two firms had differing investment styles.
“Goldman wanted to bid as low as possible to avoid overpaying. For me, the biggest risk was not offering enough and missing out on a tremendous opportunity… You often find this difference between different types of investors. Some will tell you that all the value is in driving down the price you pay as low as possible… That has always seemed short term to me. What that thinking ignores is all the value you can realize once you own an asset: the improvements you can make, the refinancing you can do to improve your returns, the timing of your sale to make the most of a rising market. If you waste all your energy and goodwill in pursuit of the lowest possible purchase price and end up losing the asset to a higher bidder, all that future value goes away. Sometimes it’s best to pay what you have to pay and focus on what you can then do as an owner. The returns to successful ownership will often be much higher than the returns on winning a one-off battle over price.”
Blackstone convinced Goldman to increase their bid, and the deal went on to generate a 62% annualised return. The experience stuck with Schwarzman and coloured his investment philosophy across all asset classes through the rest of his career. It also convinced him to beef up the firm’s real estate efforts. Blackstone made a number of hires into the real estate unit and, in 1994, raised a stand-alone real estate fund (Blackstone Real Estate Partners I) that ended up doing a 2.8x gross return.
One of the hires was a young Jonathan Gray. Recruited into Blackstone’s private equity business as a 22-year old from college, he transferred to the real estate unit in 1995. Ten years later he was running it. Most successful money managers have a defining key insight sometime in their careers; Gray had two. He was quick to tap into the commercial mortgage backed securities market to make bigger real estate transactions when they were relatively new. And he identified that public companies frequently have a lot of properties valued at less than the sum of their parts; if you can buy entire portfolios, you can often offload them piecemeal and extract strong returns,
That second insight was the foundation for one of the biggest real estate transactions in history, when Blackstone bought Sam Zell’s Equity Office Properties on the eve of the financial crisis. By then, Blackstone had raised its fifth stand-alone real estate fund, Blackstone Real Estate Partners V, a $5.5 billion fund that started deploying capital in December 2005. It had a proven track record – the first three funds all did in excess of 2x – but Equity Office Properties was six or seven times larger than any real estate deal done before. In February 2007, Blackstone bought it for $39 billion and immediately went out to sell off many of its underlying assets. Within two days it recouped half of what it paid and within two months it had sold $30 billion of assets.
The deal is indicative of the scale Blackstone operates at. Today, the firm has around $46 billion of capital ‘in the ground’ in real estate and a further $36 billion of dry powder to deploy. Some segments of real estate have struggled during the pandemic, but 80% of Blackstone’s exposure is to more resilient segments like logistics, suburban multifamily and high quality office (including life sciences).
Blackstone diversified into other areas as well as real estate. It established a “fund of hedge funds” in 1990 for partners to invest their own capital, which it then rolled out to external clients. Today, Blackstone Alternative Asset Management is the largest discretionary allocator to hedge funds in the world; the hedge funds business makes up around 15% of Blackstone’s total assets under management.
It also has a large credit business, which grew following the financial crisis. Blackstone acquired credit manager GSO Capital Partners in 2008 just at the time banks were pulling back from lending, creating more direct lending opportunities for private credit managers. Today, Blackstone is one of the largest credit-oriented managers in the world. Credit makes up around 25% of the group’s assets under management.
How Blackstone Makes Money
Blackstone makes its money from two main sources: management fees and performance/incentive fees. Over the past few years, the mix has shifted more towards management fees. Across all of its business segments, management fees now rack up at around $5 billion per year. As Schwarzman identified at the launch of his firm, private equity fees are highly scalable. Around 35% are allocated to investment professionals and other employees but the number of staff does not ratchet up linearly with assets under management. Blackstone currently employs around 3,100 people, up 54% over the past five years, during which time its assets under management are up 84%. The margin on fee-related earnings has therefore been going up at a rate of around one percentage point per year; it now stands at 55%.
Performance/incentive fees are a lot more lumpy and, in the private equity and real estate business, contingent on exits. In the last twelve months, the firm released $2.1 billion of performance and incentive fees and right now there’s another $6.8 billion sitting on the balance sheet waiting for exit events.
One of the reasons for the mix shift in fees towards management fees is the higher weighting of perpetual capital managed by Blackstone. Traditional fixed term fund structures such as Blackstone Capital Partners I and Blackstone Real Estate Partners V are analogous to ‘single crops’, to borrow Schwarzman’s farming framing. Capital is raised, deployed and compounded, but it’s ultimately handed back to investors – an intensive process to repeat. Increasingly, Blackstone has been raising perpetual capital which, unlike fixed term funds, is under no obligation to be returned to investors. Right now, Blackstone has around $170 billion of assets under management across 15 perpetual strategies. The firm gets paid incentive fees on performance based on valuations as opposed to based on realizations in sales and often the base management fees are tied to net asset value as opposed to the amount of capital committed.
A major source of perpetual capital is the insurance industry. As we discussed in Other People’s Money, one of Warren Buffett’s career-defining insights was to pair up insurance with investment management. Lower interest rates have increased the pressure on insurance companies to seek out ways to earn higher returns and one solution is for them to get closer to credit origination, which several are doing by replicating Buffett’s strategy to partner with asset managers. Blackstone recently did a deal with AIG to manage $50 billion of its assets, rising to $92 billion over time. The deal will take the firm’s total insurance assets to $200 billion when fully phased in.
As well as insurance, Blackstone has also been increasing its penetration in the retail channel. It estimates that there are $80 trillion assets sitting on household balance sheets of high net worth individuals around the world, which compares with $30 trillion in insurance and $60 trillion in its traditional institutional market. Retail allocation to alternative assets is currently very low, but Blackstone is seeking to address that via the creation of bespoke products and a support organisation. It is currently attracting retail assets at a rate of $4 billion per month.
Blackstone went public in June 2007, just four months before the stock market peak as the financial crisis brewed (lucky market timing once again). The IPO provided an exit for Pete Peterson and floated a currency that could be used for employee retention and for acquisitions. The challenge for any asset management firm – as we discussed in Zuckerman’s Curse – is to strike a balance between the interests of the asset manager and the asset owner; add a third stakeholder into the mix – an equity owner – and it compounds the problem. Blackstone reconciled this problem with an intention to be “a different kind of public company”:
“We intend to continue to manage our business with a long-term perspective, to focus at all times on seeking to optimize returns to the limited partner investors in our investment funds and to retain our partnership management structure and culture of employee ownership of our business.”
Over the past fourteen years, Blackstone has broadly stuck to that. Its stock dipped to $3.50 in the months after it priced its IPO at $31 as the financial crisis took hold but it recovered subsequently and now trades at $115. Looking back on the past five years, economics have been shared between the three stakeholders as follows: limited partner investors have enjoyed returns of around $100 billion, employees have taken around $10 billion and around $15 billion has been left for shareholders (although these interests do overlap).
In its first few years as a public company, investors were reluctant to place a high value on Blackstone’s performance fees. This led Schwarzman to complain publicly. He argued, in 2012, that public mutual fund managers traded at 16 times earnings while growing assets under management at a rate of 6% per year. At the time, Blackstone was trading at 10 times and growing assets under management at 27% per year.
Since then, Blackstone has been rerated – it now trades at around 30 times earnings. Part of that is due to the shift in business mix towards more fee-related earnings, coupled with the proven persistence of performance fees. Part is due to a change in corporate structure in 2019 which allows it to access a larger pool of potential shareholders.
Blackstone’s Secret Sauce
Blackstone highlights its ‘virtuous circle’ as a cycle consisting of three elements: investment performance, investor confidence and the power to innovate. The problem with such cycles in the asset management industry is that time lags can inject friction into them. Investment performance cannot be evaluated overnight – it can take three to five years to evaluate it; longer in the case of a fixed term private equity fund.
But Blackstone has been around for a long time now and has delivered robust performance across its strategies through different market environments (with the advantage that it has discretion to time its exits). Underlying its performance are three factors: process, scale and integration.
As an outsider it can be hard to assess any firm’s process, but at Blackstone there’s a clue in the investment style Schwarzman articulated when recalling his first real estate deal. Price is important, but what you do with the asset after you’ve bought it is more important. This was demonstrated when the firm bought Hilton Hotels at cyclically the worst possible time, just before the financial crisis, at a price that several months later looked too high; yet the deal performed well and ultimately made $14 billion for investors.
“Scale is our niche,” declares Blackstone. There are certainly very few firms able to execute deals on the scale of Blackstone. Scale allows the firm to own and invest in assets and businesses that have greater surface area for improvement. In several cases, Blackstone has used scale to create new business platforms. For example, in spring 2012, it began buying single family residential homes – it bought its first in Phoenix for $100,000. Within a few months it was buying $125 million per week and eventually it rolled its properties into a platform, Invitation Homes, which made $7 billion for investors.
Integration is possible in part because of the firm’s scale: Blackstone sees almost everything and has a pool of capital somewhere in the group to exploit it. It also practices a thematic style of investing which lends itself well to integration. Blackstone identifies macro themes and executes them across its various strategies. In life sciences, it has a dedicated fund but it also invests in specialised property in its real estate unit. Current themes it is exploring across the group are: sustainability, logistics, digital infrastructure, housing and the post-COVID travel recovery.
“Information is the most important asset in business. The more you know, the more perspectives you have, and the more likely you are to spot patterns and anomalies before your competition. So always be open to new inputs, whether they are people, experiences, or knowledge.”
Jon Gray is now President and COO and designated successor to Stephen Schwarzman at Blackstone. But as the firm shifts from Black to Gray, it is unlikely to skip a beat. The Archegos episode at Credit Suisse (see below) highlights the importance of culture at any firm, not least one built on intangibles like knowledge and risk. Blackstone is small enough at 3,100 employees that its culture can be cultivated but big enough that its culture can be leveraged. Of course, the firm has benefitted from the tailwind of a supportive liquidity environment, but across all of its distribution channels and all of its investment strategies, there’s plenty more growth to go.
More Net Interest
Matt Levine does a good job summarising the independent report commissioned by Credit Suisse on its Archegos failings. What stands out is that some people within Credit Suisse knew the risks they were running in their dealings with Archegos but they weren’t necessarily the right people and they didn’t necessarily do anything about it.
Of note, Archegos positions were persistently in violation of internal risk limits. The maximum potential exposure limit was set at $20 million during 2020, yet actual exposure fluctuated between $200 million and $500 million during most of the year. Credit Suisse solved this problem by moving the account to a different unit within the firm where risk limits were higher! By 8 March 2021, gross exposure was up to $21 billion which was large enough to merit a discussion at committee, but the issue wasn’t escalated to the executive board for two more weeks. During that time, Credit Suisse even agreed to pay across some excess variation margin to Archegos even though it was trying to get Archegos onto a “dynamic margining” system that would have sent funds the other way – a system that would have been implemented if only Archegos had returned Credit Suisse calls (“the business scheduled three follow-up calls in the five business days before Archegos’s default, all of which Archegos cancelled at the last minute.”)
The whole sorry mess reflects a problematic culture at Credit Suisse, a difficult thing to repair. There was a lot of staff turnover leading up to the default, one of the proximate causes for its fallout, and there has been a lot since. But as we observed in our piece on the matter, “you can change the head multiple times, you can change the stick, but it stays the same broom.”
A new paper asks, “Why is the United States Lagging Behind in Payments?” It is co-authored by the co-creator of Diem (formerly Libra, discussed here) – a technology looking to disrupt US payments – so it’s not exactly objective. But it makes some good points. It observes that transfers between major US banks incur fees ranging from $10 to $35 for same-day wires and compares this to the UK, where individuals and businesses have access to a free, 24/7 interbank payments system which settles within seconds and supports over 8m transactions per day. It goes on to outline the frictions that exist in the US in payments systems used by individuals, businesses and government. It suggests three ways to remove these frictions.
One is to bring deposits on a single ledger through a Central Bank Digital Currency (CBDC), so that transfers between banks are not limited by external liquidity constraints or third-party rails.
The second is to follow countries such as India and Mexico and increase the throughput of always-on real time gross settlement systems. This is the model the Federal Reserve is pursuing with the introduction of FedNow, targeted for 2023.
The third is to facilitate the growth of interoperable, stablecoin payment rails by creating the right regulatory framework for these new types of networks to safely increase competition in payments.
Diem (formerly Libra) is a play on the third, although it is hedging itself by also embracing the first. The second is a solution worth watching.
We discussed Monzo here a year ago in The Good, the Bad and the Ugly (Monzo was the bad). This week the company filed its accounts for the year up to the end of February 2021, and yet again auditors raise question marks around the bank’s capacity to carry on as a going concern.
“Our Directors have assessed our ability to continue as a going concern and are satisfied that we have the resources to continue for the foreseeable future. But, there is a risk we won’t be able to execute our business plan, which could impact our ability to generate a profit or raise enough capital to meet future regulatory capital requirements. Because of these obstacles, the Directors recognise there continue to be material uncertainties which may challenge our ability to continue as a going concern.”
The company also highlighted that it is under investigation by the FCA over anti-money laundering breaches with potential criminal as well as civil liability.
The UK is home to several challenger banks including Revolut (discussed two weeks ago), Starling and Monzo. They’ve each trodden a different path and risen to the challenge of the pandemic in different ways. Starling embraced government loan schemes to boost its loan portfolio, Revolut diversified into trading, but Monzo looks to have stood still. Customer deposits more than doubled, to £3.1 billion, but the bank said fewer customers were using their accounts on a weekly basis – 55%, down from 60% – which it blamed on limited spending in lockdowns. Monzo is unlikely to be the first to IPO.
Well, it’s no longer hot in London; now it’s raining. But I may still take some time off over August. If you have any ideas, opportunities, proposals, observations, or anything else you want to talk about, do get in touch by replying to the email or via Twitter or LinkedIn.