Brighter 2017 for Blackstone

Blackstone BX reported strong fourth-quarter results, and after a challenging industry environment in 2016, we think the alternative asset manager's outlook is beginning to improve.

Entering 2016, we were concerned about market volatility, lower IPO activity, and tighter credit markets making it difficult to exit investments and make new leveraged deals. The weaker level of exits in private equity hurt incentive income, and we were also concerned that a decline in the level of exits meant less capital for limited partners to recycle into new funds, reducing Blackstone's inflows. We were optimistic that there would be more investment opportunities available, though the pricing environment was difficult with more than $800 billion in dry powder across the industry and median deal multiples at more than 10 times EBITDA, according to PitchBook data, far higher than recent years. Broadly, with more aggressive economic growth, deregulation, and lower taxes on deck, we think these trends will take precedence in 2017, improving the industry outlook by accelerating exits at portfolio companies, investment returns, and investment activity and offering the potential for an attractive C-corporation conversion from a limited partner structure.

Generally, the industry has been able to manage through a less productive 2016 and position itself for a better 2017. With very weak IPO activity, tighter credit markets, and an 18% decline industrywide in private equity-backed exits per PitchBook, private equity firms generally used secondary buyouts (selling to another financial firm), which represented 47% of activity in 2016, to close the gap. Credit funding may not have been provided up front by banks operating under tighter leveraged loan guidelines, but firms were able to acquire additional leverage post-close or use alternative nonregulated direct lenders. Unsurprisingly, investment activity for Blackstone was just $23 billion in 2016 versus $32 billion in 2015. The firm's inflows for the year at $70 billion were down from $93 billion last year, and realizations were down to $39 billion from $42 billion.

However, investment returns remain strong, with credit delivering gross returns of 23% and 18% across performing credit and distressed strategies and real estate and private equity delivering 11% returns from a carrying value perspective. Fund managers are still consolidating and outsourcing to alternative asset managers to chase these returns, as Harvard recently announced it would halve its staff and outsource its real estate and other assets under management to external managers, and we wouldn't be surprised to see Blackstone included. We also think that under the Trump administration, Blackstone would be wise to consider converting to a corporate structure versus a master limited partnership, which would broaden its shareholder base, open it up to index ownership, and probably remove a lot of the technical barriers that have promoted a long-standing multiple gap between the alternatives and the traditional asset managers.

Blackstone's fourth-quarter numbers were good. Revenue jumped 79% to $1.6 billion thanks to a near tripling in incentive income, economic income improved 86% to $812 million, and assets under management increased 9% to $367 billion due to diversified inflows across credit, private equity, real estate, and solutions. Distributable earnings were down 21% to $692 million, mainly because BCP V exits were not contributing to distributable income. The fund had yet to hit its hurdle return, and the investments liquidated were at a multiple of invested capital of around 1.3 times, versus 2.1 times before 2016, and 2.7 times in the remaining holdings (about 75% of the portfolio). The firm has about $8.7 billion in realizations under contract that should easily push distributable earnings to over $700 million in the first quarter of 2017.

Broad Scale Sets Blackstone Apart
We believe Blackstone has a wide economic moat. The company is the largest and most diversified alternative asset manager with the strongest record of strategy innovation and fund-raising. Since 2007, Blackstone has inbounded more than $130 billion in assets under management to brand-new strategies, by our estimates, and since 2011, more than $200 billion to total AUM, more than its next four largest peers combined. If separated into a new unit, Blackstone's new strategies would be the third-largest stand-alone alternative asset manager after Carlyle CG and Apollo APO , which is a significant achievement. More important, once these assets are part of Blackstone, the partnership can earn fees for 10-11 years, the useful life of a private equity fund. Institutional investors (nearly 80% of industry AUM) also prefer to invest in established managers, and an estimated 90% of industry asset flows goes to funds with assets over $1 billion.

Blackstone is unique among publicly traded alternative asset managers in that it has scale across multiple key asset areas (real estate, private equity, credit, and hedge fund allocation). This means that it is nearly always a contender for new assets, as it has access to more than 1,300 limited partners and more than 900 investment professionals. Furthermore, we estimate that 60%-70% of Blackstone's limited partners invest in more than one fund, and about 20% invest across all four major Blackstone divisions, a sign of a very strong cross-selling platform. Because of the broader scale of Blackstone's operations, the firm is able to better anticipate limited partner desires and develop or acquire new strategies ahead of peers, as well as put more money behind its best investments thanks to idea sharing, generating better-than-average fund performance and increasingly serving as a one-stop shop for limited partners.

While Blackstone's strengths in private equity and credit are key calling cards for new limited partners and deals, we're also impressed by Blackstone Alternative Asset Management and the real estate operations, which are both strong contributors to the firm's moat. BAAM has been one of the larger allocators of capital to hedge funds via a fund-of-funds model. We view it as a key source of competitive advantage for Blackstone because of its ability to develop innovative and custom strategies (typically through commingled or separately managed accounts), rapidly expand its client base (which currently includes more than 500 clients), and earn extra fees from its intangible assets (namely, its reputation and existing relationships). The key part of the attraction for limited partners to BAAM, in our view, is Blackstone's reputation and ability to access up-and-coming managers. Hedge fund managers also want to work with Blackstone in order to earn its seal of approval.

We view Blackstone's real estate segment as another key contributor to its wide moat. The company's scale in this segment is such that it alone among its peers can purchase entire real estate portfolios (or real estate investment trusts), which gives it access to better investment opportunities than its rivals, which can typically purchase only single buildings. This scale advantage gives Blackstone an edge in situations where distressed sellers are looking to offload an entire real estate portfolio rather than engage in single-asset sales. Blackstone's purchase of $14 billion in GE Capital assets is a prime example. Blackstone was granted an exclusive bid because of its reputation for obtaining the needed capital and closing a transaction quickly. Blackstone has a history of working with GE, having purchased $2.7 billion in U.S. apartments from GE in 2013. These types of long-standing relationships with buyers and sellers are critical sources of exclusive deal flow, and Blackstone's relationships are among the most extensive.

We also think the transaction illustrates the breadth of Blackstone's product portfolio, which is a significant advantage for closing complex deals. Blackstone is acquiring assets from GE through its global real estate fund, its European real estate fund, its real estate debt fund, and its publicly traded commercial mortgage REIT. The depth of Blackstone's product portfolio means that it can acquire multiple types of assets in a single transaction, making it more attractive to a seller compared with buyers that may want to pick and choose certain types of assets. Blackstone's product portfolio also means that it has the capital needed to go after large-scale transactions, as well as the ability to allocate assets to funds and limited partners with similar returns expectations and risk tolerances, strengthening limited partner relationships. Last, Blackstone is plugging EUR 1.9 billion of European and retail assets into existing European and retail platforms, immediately strengthening these assets by aligning them with experienced management teams, and positioning itself for potential platform sale opportunities.

Two other deals that have demonstrated the company's unmatched ability to cut deals were the 2007 purchases of Hilton and Equity Office Properties. Both deals--sized at $27 billion and $39 billion, respectively--were far larger than any other peer could pull together for a real estate-based deal. With Equity Office Properties, Blackstone had the relationships in place to offload $27 billion in assets within weeks of closing the deal, immediately earning a solid return, a process that peers would find nearly impossible to duplicate.

Real Estate Investments Bring Some Risk
Blackstone's private equity and real estate investments are highly illiquid. Tightened credit conditions could limit the firm's ability to move into new investments, while weak economic conditions and difficult equity and credit markets could affect not only the value of Blackstone's investments, but also its ability to cash out. Investments in real estate also subject the firm to the risks inherent in owning and operating real estate and related businesses and assets. With incentive and transaction fees accounting for a significant portion of annual revenue, the volatility inherent in these types of fees can have a major impact on the firm. Our fair value estimate currently anticipates steady or rising fees across Blackstone's funds, meaning that it would be too high if fees were to fall.

More important, poor investment performance can affect revenue, profitability, and cash flows and potentially obligate the firm to repay carried interest earned in prior periods. It could also have a negative impact on the company's ability to raise new capital for future investment funds, given that limited partners typically recycle distributions from earlier funds into new ones. Any financial stress experienced by the firm would be compounded by the fact that Blackstone has taken on a fair amount of debt during the past few years. There has also been growing support for greater regulatory oversight of private equity and hedge funds, as well as calls for higher taxation of carried interest, which could undermine some aspects of the business model used by Blackstone.

Stewardship Is Exemplary
We think chairman and CEO Stephen Schwarzman and the other general partners at Blackstone have run the firm about as effectively as they could have in the aftermath of the financial crisis, taking full advantage of the dislocation in the equity and credit markets to expand the company's operations, primarily in real estate and credit. Its success with its hedge fund solutions segment is also worth noting.

In our view, Blackstone's investments in its global offices, its development of new strategies and capabilities, and the hiring of human capital to staff and run these operations in the aftermath of the financial crisis have been very successful. As a result, the company is far less dependent on its private equity operations and far more balanced overall than any of the other publicly traded alternative asset managers.

There are governance concerns with the limited partnership operating structure for unitholders. Schwarzman and his executives have near-complete control over the firm's operating and investment strategies as well as the makeup of the board, and unitholders have limited say here. That said, Blackstone insiders own about 48% of the firm's units (and retain 53% voting control), as well as additional investments in their funds, which encourages them to focus on unitholder interests. Overall, we consider Blackstone worthy of our Exemplary stewardship rating.