Wednesday, March 21, 2007

Would You Buy Stock from this Man?

I am sure I have not been alone in noodling in my spare time over whether The Blackstone Group will indeed come to market with an IPO and, if so, what said IPO would look like. I await the rumored prospectus with bated breath.

While the media and punditocracy have been busy doing the same, a superficial reading of their output indicates that most of said experts have not devoted much time to thinking carefully about what indeed might happen. (A cynic might ask why I am surprised. I have no good answer.) A dominant strain in most of this commentary seems to assume that Blackstone will somehow collapse the limited partnership fund structures it has carefully constructed over many years into the financial equivalent of a 1960s conglomerate (think ITT) and subsequently offer Jane and Michael Doe suitably engraved stock certificates therein. How these authorities think Blackstone will be able to convince its LPs to consent to such a wholesale (and probably financially-, operationally-, and tax-inefficient) restructuring is beyond me and, I suspect, them as well.

Other pundits (or sometimes the same ones) wave their hands airily and talk about the IPO becoming a source of "permanent capital" for Blackstone's PE operations. Again, press these insta-experts on exactly how this might happen, and suddenly an urgent phone call lights up their other line. Yes, KKR did raise $5.8 billion on the Euronext exchange last May to create a publicly traded "Super LP," which is designed to invest in regular KKR-sponsored private equity funds, coinvest in portfolio companies alongside KKR, and generally invest in all sorts of opportunities identified by—you guessed it—KKR. Sort of like a mini-CalPERS with a Henry Kravis fixation. But said vehicle was carefully constructed to avoid the '40 Act (don't ask) and ERISA regulations (please don't ask), so the only retail investors who can buy the damn thing reside outside of the United States. Onshore, only rich dudes and selected institutions make the grade. Oops.

"Well," some say—these are the ones who actually read the Financial Times more than once a quarter in the Heathrow Airport arrivals lounge—"look at 3i." Yes, let's. Nice company. Very clean. Uses its permanent equity capital to invest in buyouts, venture capital, etc. and hives off a healthy dividend every year to boot. Problem is, its shareholders participate across 3i's entire portfolio. Either you figure out a way to collapse the entire Blackstone portfolio into one neat entity (see paragraph two, above), or you resign yourself to the fact that you are raising permanent equity for a brand new, separate fund, with all the hoo-hah that entails.

From my poorly educated, outside-the-tent perspective, the only IPO alternative that makes any sense is offering shares in Blackstone qua Blackstone, excluding its portfolio investments. Investors would have an equity claim against the fee revenues Blackstone earns as General Partner by investing its LPs' money (the famous "2 and 20"), plus other fee activities like its advisory and restructuring business. Shareholders would profit alongside Blackstone's partners from their skills in raising money, investing it wisely, and offering fee-based advice. Sort of like Goldman Sachs minus the capital-intensive trading operations or, more nearly, Greenhill & Co.. The major difference is that Blackstone's business has a far larger exposure to the fees generated from lumpy, intermittent private equity activities than from its other (presumably smoother) transaction advisory business. Whether that makes its results more or less volatile than, say, a Greenhill going forward will depend in large part on your views of the cash flow diversification inherent in Blackstone's huge PE portfolio versus the sustainability of the current activity level in the M&A market.

Alignment with Blackstone's partners and management should be pretty good in this structure, since the economics to outside investors will be driven by the same factors which compensate Blackstone's professionals today. The only potential problem with this scenario is the use of proceeds from the IPO. As described and practiced, Blackstone's role as fund GP requires very little capital: they get all the money for their electric bills, Park Avenue office space, and deal transaction expenses directly from their fund LPs. Plus, pure advisory business has always required very little money to run. (Co-founders Pete Peterson and Steve Schwarzman famously floated the Blackstone shingle with a measly $400,000.)

Therefore, if IPO investors fork over, say, $4 or 5 billion for their shares, the only obvious place to wire the money is into the personal bank accounts of Schwarzman, Peterson, and the other equity-holding Blackstone partners. Then you run the risk of seeing what happened when Goldman Sachs partners were finally able to cash in their IPO shares: a massive brain drain of the most senior and experienced talent to the shores of the Costa del Sol and the Côte d'Azur.

Never mind, though: people seem to have gotten over the reverse-graying of Goldman Sachs, and I am sure they will do the same with Blackstone. It is time to turn to the investment thesis.

Before we do that, though, if you really want to know what drives the private equity market, who is good and why, and what an expert practitioner thinks about current trends in megafunds and private equity overall, visit Going Private. If you have 10 more minutes to waste with me, read on.

The private equity business is pretty simple. Hard, yes, but simple. In my view, there are four ways PE firms can create value in their portfolio companies:
1. Buy cheap. In other words, buy cheap relative to the company's potential value. This does not necessarily mean you buy at a low multiple or even that you bid the lowest clearing price possible. It means you see more potential value in the business than you are being made to pay for it.

2. Finance well. Not just cheap debt. The right kind of debt, with the right kind of covenants, and enough flexibility to accomplish the strategic plan you developed in your value thesis.

3. Improve the business. Cut costs, yes. Or not. Invest; acquire; divest; restructure; whatever. Do what it takes to create the value you saw in (1), above. This takes time and effort. It is hard, and often not very pretty. You may change your mind, and reverse direction, more than once. This is where even the best publicly-owned corporations have a difficult time matching the speed, decisiveness, and willingness to inflict and endure pain that a good financial sponsor owner does. This is where the rubber meets the road.

4. Sell well. Time the market. Look for tailwinds. Mail big checks to your LPs.

Of course this is a simplistic view (I am an investment banker, after all), but it is correct in outline. The interesting thing, to me, is that very little of this model is dependent on favorable conditions in the equity or debt markets. Good financial sponsors have been making mouth watering returns in good markets and bad, up cycles and down, with double-digit interest rates and single for a long time. It's a good model, and an important part of our capitalist system. Unlike the public equity markets—which for all their faults are pretty damn efficient funding mechanisms for a broad range of companies in a broad range of situations (and are many multiples of the size of the PE market, to boot)—private equity is the ideal capital provider for businesses, public and private, that need to be transformed. Call it the OR, intensive care unit, and physical therapy ward of financial capitalism.

Blackstone may be drifting from this model, due in large part to its size. Equity Private seems to think so, at least by implication. She would know; I do not. I will say, however, that I have seen up close and personal the real effects of diseconomy of scale in financial services. It's not pretty. And it's not just Citigroup.

That being said, Dear Reader, I only give stock tips on micro-cap gold mining stocks and emerging "cleantech" companies. Whether or not to invest in The Blackstone Group IPO I leave up to you.

If you are interested, however, in anticipation of the eventual issue prospectus I would like to point you to a couple sources which might help you calibrate your return expectations from investing in Blackstone or any other PE IPO. Interestingly enough, they are both from CalPERS, an entity with quite a bit of experience in PE investing and a refreshingly clear website for a governmental agency:

· "Understanding Private Equity Performance," with a nifty little graph on the "J-Curve Effect" of PE investing, shown above. (By the way, J-curves happen in all sort of industries. Are they "J"-ier in private equity?)

· A table describing the returns CalPERS has earned from alternative investments (including PE) on its $35 billion portfolio

Until we meet again, keep your eye on the prize, your mind in the game, and your hand on your wallet.

© 2007 The Epicurean Dealmaker. All rights reserved.