Description

I. SUMMARY THESIS

• Leading alternative asset manager (AAM)

• BX is the most liquid among AAMs, accounting for approximately half of sector float

• AUM of $356Bn is 2x the next largest alternative asset manager, and is relatively diversified across Real Estate (29%), Private Equity (28%), Credit (24%), and Hedge Fund Platform (19%). This is in contrast to other AAMs that generally skew toward a single asset class

• Blackstone’s business model encourages long-term decision making

• Capital is contractually locked up for an average of 8.5 years

• Fund managers have the flexibility to choose the timing of their asset exits, and can wait out unfavorable market conditions within a ~2 year window. This is a major advantage over traditional managers which is not reflected in GAAP earnings

• Institutional customers create an additional layer of stickiness with their reluctance to change managers (institutional inertia phenomenon)

• BX is capital light, and earns management and performance fees by investing LP capital. This is similar to the concept of investment float at top insurance companies

• BX has a $2.9Bn net cash position as of June 2016, in addition to an untapped $1.1Bn credit revolver

• The market is under-estimating BX’s ability to continue compounding AUM at >10% per annum

• AUM has grown at 20% annually since 2010, while fee-related earnings (“FRE”) have grown at 16%

• Management estimates that total value for a BX share over a 10-year period is $100-125, implying an IRR of ~20% annually (see Exhibit 3)

• BX is trading 34% below its year-ago price because of short-term macro concerns:

• 2H 2015 was defined by near-panic in the high yield debt markets, punctuated by the sudden closure of Third Avenue’s Focused Credit Fund. BX’s share price declined 30% in the 6 months ending December 31st 2015.

• This was immediately followed by a rapid stock market decline in Q1-2016, which depressed asset realization activity.

Despite short-term concerns and q/q volatility, Blackstone is a serial compounder with solid investment results to justify its continuing asset growth; net IRRs since inception are 16% for real estate, 15% for PE, and 14% for Credit. We calculate a fair value per unit of $40 for Blackstone, which implies 55% upside from the current price.

For investors with a long-term orientation, we recommend a long position at $26 or below. BX is a high-beta stock that trades on short-term results and macro-economic data, so investors should maintain the flexibility to add on dips. It should be noted that BX is not the only AAM to be compounding capital effectively. But it is unique in offering a combination of liquidity, asset diversification, and consistent returns.

Brief Trading History

• June 2007: BX units went public at $35 shortly before the financial crisis

• 2007-2009: Real estate, credit, and stock markets tanked simultaneously. Financial stocks moved down accordingly.

• Jan 2013-Dec 2013: U.S. averted a fiscal cliff and macro-economic data improved. BX’s AUM base continued to compound, and BX stock price eventually recovered to IPO levels

• Jun 2015-Dec 2015: market became concerned about high yield debt fundamentals, some of which was related to oil & gas debt. BX stock declined 30% in 6 months.

• Jan 2016-Feb 2016: stock market volatility dampened asset realizations, contributing to weak Q1-2016 results

• July 21th 2016: BX announced stronger-than-expected Q2-2016 results.

Institutional Shareholders Include Beijing Wonderful Investments, China Investment Corp, BNY Mellon Fund Advisors, Fidelity, Morgan Stanley Investment Management, Janus Capital, Swedbank Robur Fonder AB

II. WHAT THE MARKET THINKS

Since 2015, the market has been bearish on AAMs, which have seen average y/y stock price declines of ~40%. There are several reasons for this:

• AAM share prices are closely correlated with dividend pay-outs. In 2015 and 2016, distributions were muted as AAMs shifted toward fundraising and deployments.

• Over the same time, AAMs experienced negative EPS impacts from mark to market changes and cyclically muted carried interest.

A thoughtful slide presented by Apollo’s management team illustrates the disparity between how the market values S&P earnings compared to those at asset managers. AAMs trade at a >40% discount to S&P earnings, despite a 4x dividend yield and history of high cash returns.

Apollo and AAM Industry vs Industry (2011-2016)

Source: APO, Deutsche Bank Global Financial Services Conference, 5/31/2016

The negative AAM sentiment has clearly affected Blackstone:

• Between June 2015 and June 2016, FE-AUM increased 11% and Q2-2016 fee-based earnings increased 27%. Despite this, and even after the post earnings run-up, BX’s share price is still 34% lower from a year ago. The current dividend yield of 10% is near an all-time high, and compares to an average yield of 5-6% since BX’s IPO.

Schwartzman frames the market discount this way:

“The S&P is yielding around 2% today. It's incredibly low. And we don't see why our mostly locked up fee earnings shouldn't be capitalized in our stock price at a similar, if not, lower yield to the S&P. You could do the math. A 2% yield. The same as the S&P. On $1 of fee related earnings implies a $50 stock price … On a 3% yield, which is a 50% premium to the S&P for long-term locked in cash income and I would not understand why you'd need a premium, it implies a stock price of over $30 and that's giving no consideration to realizations…” (Q2-2016 earnings call)

As a final note, many investors are not able to hold BX for technical reasons. Blackstone is a publicly traded partnership (PTP) whose shareholders receive a K-1 tax form instead of a 1099. Non-tax paying investors (e.g. foundations) may not care about BX’s low tax model. Blackstone also has a low float, complex organization structure, and volatile economic earnings.

Key Value Drivers

• Pace of fundraising (drives AUM and FE-AUM growth)

• Asset deployments (drives FE-AUM growth)

• Asset Realizations (drives carried interest, DE, ENI)

• BX generally sees a step-up when assets are sold: “When we sell an asset, we get something like 20% to 30% higher realizations in our mark on average. And that's true both Real Estate and Private Equity. So it's a little hard to say that we're marking -- undermarking 20%. But -- so that I think you can feel the assets are conservatively marked in both portfolios in a similar way” (Q1 2016 earnings call)

• Management Fee Revenue as a % of FE-AUM – determined by asset mix and pricing power

III. BUSINESS OVERVIEW

Blackstone is an alternative asset manager with top franchises across four business lines – real estate, private equity, credit, and hedge fund solutions. As of June 2016, Blackstone had $356Bn in total AUM and $266Bn in management fee-earning AUM: Private Equity ($100Bn AUM / $69Bn fee-earning); Real Estate ($103Bn AUM / $67Bn fee-earning); Credit ($85Bn AUM / $65Bn fee-earning); Hedge Fund Solutions ($69Bn AUM / $65Bn fee-earning)

• Sources of Revenue

• Between 2010 and 2015, Blackstone earned management and advisory fees equal to ~1.35% of fee-eligible AUM. The fee ratio was higher in 2010 (1.54%) compared to today as BX has diversified its AUM base toward credit and secondary hedge funds

• As investments are realized, profits are typically shared 80% to investors in private equity funds and 20% to BX, subject to clawback provisions and minimum invested hurdles (typically 7-9%)

• BX also earns 100% of gains from investing its own balance sheet

• Rising interest rates are an often cited as a risk for AAMs, but the effect on BX’s business model is nominal barring a dramatic rate hike.

• BX has primarily fixed rate debt, while its credit and mortgage REIT investments are mostly floating rate.

• In a higher interest rate environment, the cost of private equity acquisition debt would be higher, but the flip side is a better selling environment.

• Real estate rental rates generally go up in a rising rate environment.

• In the case of substantial interest rate hikes, LPs may substitute alternative investments with traditional fixed income instruments. But this appears to be a remote probability today; BX’s average IRR on credit investments is 14%, compared to near-zero yields on Treasuries and corporate bonds.

IV. BUSINESS QUALITY

• A capital Light business model allows BX to earn 30-40% distributable earnings on unconsolidated firm capital

• Because of its partnership structure, BX has a low blended tax basis. Tax expense has averaged 10% of ENI over the last five years.

• Public market fluctuations and mark-to-market accounting can cause GAAP earnings to decline dramatically. In 2015 for example, distributable earnings grew 25% while economic net income (ENI) fell ~50% (see Glossary)

• Blackstone has multiple sources of moat

• High switching costs

• Excluding hedge fund solutions, Blackstone’s assets have an averaged remaining life under lock-up of 8 years.

• Fund life is given as a range (e.g. 8-12 years), so managers have discretion on the timing of investment exits.

• Institutions (80% of industry AUM) are famously slow to change managers

• Moderate Network Effects

• 60-70% of BX’s limited partners invest in more than one fund, and about 20% invest with all four asset classes.

• The more investors BX has, the easier it is to launch and cross-sell new products

• Power in conservative-think, as Morningstar’s analyst opined: “We think Blackstone is becoming a close substitute for the IBM of the industry, where no one was fired for allocating capital to the company”

• Intangible Assets

• Blackstone has one of the strongest brands among alternatives, with a track record of long-term out-performance (see Exhibit 4)

• BX’s edge comes from collective decades of industry experience and relationships

• Scale and product diversification tamp volatility

• Some evidence of pricing power: BX raised its management fee on BCP VII from 1.25% to 1.35% without sacrificing investor demand

• Cost advantages

• Robust balance sheet allows BX to obtain favorable credit terms.

• In a tough lending environment, BX would be among the last to lose access to credit

• Efficient Scale

• As BX grows relative to other asset managers, it see less competition for mega assets by virtue of being able to write very large checks. A recent example of this was Blackstone + Wells Fargo’s $23Bn purchase of GE real estate assets in April 2015

• Information advantage from scale may allow BX to pick up more quickly on market dislocations

V. INDUSTRY ANALYSIS

• Alternative assets are growing at ~2x the rate of traditional assets, with room to grow. Recent surveys of institutional investors show that 80-90% plan to increase AAM allocations over the next 1-3 years

• Large diversified managers (e.g. Blackstone / KKR / Apollo) are disproportionately taking share as LPs consolidate their assets with fewer trusted managers.

Porter’s 5 Forces

• Competitor Rivalry is moderate and decreasing

• Direct competitors include other alts funds, sovereign wealth funds, and corporate buyers (private equity).

• Banks and SIFIs are divesting assets and scaling back on credit investments in response to regulatory pressure

• With the Department of Labor Fiduciary Rule, a number of banks and SIFIs are also scaling back their wealth management practices (recently Barclays, Deutsche Bank, AIG, MetLife)

• Bargaining power of suppliers

• Investment targets across PE / real estate / credit are fragmented

• Growth in retail channels such as SMAs (separately managed accounts) and publicly traded vehicles are cutting out institutional intermediaries.

• Bargaining power of customers is limited

• Fragmented base of >1,300 limited partners

• US pension funds and FoFs are in decline, while funds from sovereign wealth and retail investor channels are increasing

• LPs have recently banded together to encourage fee transparency.  

• The Institutional Limited Partners Association (“ILPA”, representing ~300 institutional investors and $1Tn of private equity investment) has drawn up the first standard fee reporting template for the industry

• CalPERS began publishing its private equity costs, encouraging other LPs to follow suit

• While some AAMs have reported increasing fee pressure, BX’s business has been buffered by strong investment results and brand recognition

• New Entrants are a low threat

• Very difficult for a new-comer to replicate Blackstone’s capital base, customer relationships, and brand name.

• Well documented consolidation trends are favoring established managers with product and geographic breadth

• Threat of Substitutes

• Endowments and pension funds can choose to in-source their own investment teams. In practice, this is resource intensive and often inconvenient (it shifts fiduciary duty directly to the investment committee), as well as only feasible for the largest investment offices

• Growing pressure from LPs wanting to co-invest alongside their GPs

• Some risk from traditional investment vehicles (index funds, mutual funds). However, equity mutual funds are falling out of favor as the industry “bar-bells” toward passives and alternatives.

• BX funds have handily outperformed passive indices since inception, which reduces substitution risk:

Credit Suisse Research, May 2016 (VTI and BND return reflects total return since inception;

VTI = Vanguard Total Stock Market ETF; BND = Vanguard Total Bond Market ETF)

VI. FUNDRAISING STRENGTH

• BX has been much more effective at fundraising than peers. Fee-earning inflows in the last 24 months surpassed BX’s next three competitors combined

Source: Credit Suisse, May 2016

• ~80% of Blackstone’s net AUM inflows over the past 5 years have come from organic initiatives

• Distribution channel growth

• 14% of 2015 organic capital inflows came through retail channels. BX recently launched several new products (BTAS, Harrington Re) to make alternative investments even more accessible to HNW investors

• Expansion into newer products

• Recent product introductions accounted for an estimated 40% of investments

• BX’s fund of funds platform, BAAM, grew from the fifth largest hedge fund solutions platform before the financial crisis to the largest today, and now accounts for ~10% of all HF capital inflows

• Similarly, real estate previously comprised a small part of the overall business, but compounded assets at 30% p.a. between 2005 and 2015.

• BX outperformed its competitors through the financial crisis. BREP V (December 2005 vintage) is Blackstone’s worst-performing real estate fund, and achieved an 11% net IRR

• Prior competitors include the real estate investing arms of institutions such as AIG, Morgan Stanley, Goldman Sachs, and Bear Stearns. These now face increasingly onerous regulatory restrictions on their investment activities, in addition to pushback from poorly timed real estate investments

• Alternative assets are expected to continue outgrowing traditional assets.

• The latest survey by Northern Trust (July 2016) showed that 80% of institutions planned to increase allocations to alternatives, especially in PE and infrastructure

• Low fixed income returns and volatile equity markets are both positive drivers for industry AUM

• Increasingly stringent capital requirements have led to banks’ asset divestitures in the US and Europe, which has allowed alternatives to grow market share in direct lending, etc.

• The international opportunity is still relatively under-penetrated. Recent BX funds have raised ~50% of capital from international clients, compared to 15-20% on prior funds.

VII. MANAGEMENT PERFORMANCE & INCENTIVES

• Stephen Schwarzman (age 69) co-founded Blackstone with Pete Peterson in 1986, and still serves as the chairman and CEO today. He continues to lead conference calls, and is an avid champion of the company’s long-term intrinsic value.

• Management collectively has strong monetary alignment with shareholders.

• Schwarzman effectively holds ~$6Bn of BX stock at the current price (a year ago, his shares had traded for 35% more). Schwarzman loves to remind investors that his conservative estimate of BX’s intrinsic value implies a 4x to 5x return over ten years

• BX requires executive officers to invest their own capital in BX funds, and extends loans for this purpose ($332M balance as of December 2015)

• Executives are required to hold a minimum of 25% of vested units for the earlier of ten years after the vesting date, and one year after leaving BX

• The team has a track record of balancing AUM growth with strong net investment returns (15-16% over 20+ years)

• Operationally, BX is seen as an early adopter among alternative managers – the most aggressive at expanding AUM following the financial crisis; among the earliest to go public; a leader in establishing new offices (London office in 2000, Paris in 2004, Mumbai in 2005, Tokyo in 2007, Beijing in 2008, Singapore in 2013; equity stake in Patria in in 2010)

• Talent and retention:

• Current investment team is 900 professionals. Management stresses a culture of information-sharing, and has a single global investment committee that meets weekly.

• Former CFO Mr. Tosi resigned to become CFO of AirBnb in July 2015, and was replaced by Michael Chae.

• Key man risk: Steve Schwarzman has been closely connected with the firm for decades, and is obviously a very large shareholder

VIII. CAPITAL ALLOCATION

• Blackstone’s Capital Allocation history shows a strong preference for organic growth and conservative leverage use

• Where BX has acquired businesses (e.g. Strategic Partners and GSO), it has subsequently grown these acquired businesses multi-fold.

• Strategic Partners had a $2Bn flagship fund at the time of its acquisition in 2013 and currently manages $16Bn.

• 40% of the $34Bn in investments that BX made during the 12 months ended March 2016 were in new product introductions, including core+, Strategic Partners, and Tactical Opportunities

• Blackstone is conservatively levered with a ~$3Bn net cash position and $1.1Bn of undrawn revolver capacity

• Both S&P and Fitch have assigned BX A+ / A+ credit ratings

• Debt is predominantly fixed rate, with long-term maturities (2019 through 2045), and minimal currency exposure risk

• Distributions to unitholders represent BX’s largest use of cash, and approximate 85% of distributable earnings

IX. VALUATION MODEL

Our preferred valuation approach is to use a SOTP analysis, valuing (1) recurring fee-related earnings (2) carried interest and (3) the value of net cash and cash equivalents. The base case scenario assumes that FRE growth declines to the HSDs over the next 10 years, and implies a $40 fair value

Components of value

1. NPV of Fee-related earnings (FRE). These are recurring management fees that grow in line with assets. FRE growth has trailed FE-AUM growth slightly (16% vs 18% since 2010) only because of expansion into lower-fee products (credit, secondary hedge funds) and the timing of fee holidays (typically the first 6 months of a new fund)

• Management assumes that AUM growth slows to 12% from the recent 20% CAGRs. Our base case takes a haircut to this and assumes 10% fee growth in period 1, followed by 8% in periods 2 and 3.

• Base case FRE per unit value is $20.

2. Value of carry if liquidated today

• Assume a 25% premium on exit for Blackstone’s real estate and private equity investments, which is in line with historical results.  Because credit and hedge funds are liquid assets, we assume they are carried at fair value.

• Using these assumptions, we get an implied carry value of $17 per unit:
  
  

3. Net corporate cash and liquid investments = $2 / share

Illiquidity Scenario / “What if everything goes wrong?”

While the above assumptions are conservative (e.g. assigning no value for future growth in carried interest value), they do not represent a worst case scenario. What if fee income were to stop growing? What if BX were forced to exit key investments during an unfavorable market environment? These are questions that shareholders are probably thinking about after witnessing the illiquid markets of early 2016.

For this scenario, assume that in a weaker macro environment, BX is much less efficient at monetizing carried interest:

• BX sees a 0% mark up on assets upon exit, instead of the >25% mark-up it has historically seen (from a combination of conservative accounting and opportune exit timing). This diminished carried interest value is realized evenly over 5 years

• Assume BX’s credit investments see a permanent mark down of 10% against a backdrop of energy headwinds.

• FRE sees 0% growth from June 2016 levels, which implies stagnant net AUM.

Based on the above assumptions, BX has a stress test value of $22:

In practice, exiting investments abruptly and at unfavorable prices goes against BX’s model (to say nothing of management’s business acumen and monetary interests), but this illustrates a theoretical floor on intrinsic value.

Yet at the current price of ~$26, the market’s imputed fair value is pretty close to this. This is to say, if the market were right in its assessment of value, then Blackstone would only be worth the sum of net cash, book value of accrued carried interest, and a future stream of flattish management fees.

Other Valuation Frameworks

• Management thinks about intrinsic value relative to investment returns, AUM growth, and normalized dividend yield. By their math, BX should be worth $100-125 by 2025 (Q4-2015 earnings call)

• Research analysts focus on economic net income (ENI), and generally assign different multiples to different earnings streams. E.g. Deutsche Bank values fee-related earnings at 16x and incentive earnings at 9x. The gap in multiples signals that the sell-side is extremely uncomfortable with the timing and unpredictability of performance income. However, performance income is not only higher margin, but the dominant source of cash earnings, contributing 44% more than fees between 2009 and 2015. This risk vs uncertainty framework creates an opportunity for long-term investors to acquire BX at a discount.

• While it feels logical to compare EV / AUM across traditional and alternative managers, the differences in fee structures make this impractical. Fees are lower for passives and credit funds, higher for actively managed equity, and higher still for alternatives. Within a single asset class, investors can also pay “premium” fee rates for reputation and growth potential.

• A fund with a strong track record in a desirable asset class may be able to charge 2% management fee + 20% performance carry, while a less successful fund managing the same asset class may only be able to get 1% management + 10% carry above a certain hurdle rate.

Glossary

Fee related earnings (FRE)
Calculated as the sum of management fees, dividend revenue, and other income, less compensation and other operating expenses. FRE excludes earnings from performance fees and investment income, and can be thought of as recurring earnings that grow with AUM.

Distributable earnings (DE)
Calculated as the sum of management fees, interest and dividend revenue, realized performance fees and realized investment income,
less compensation and realized performance fee compensation, and other operating expenses.

DE is a measure of cash available for distribution to unitholders.

Economic Net Income (EI)
Most comprehensive (but volatile) measure of earnings, which includes the effects of mark-to-market portfolio changes. Can be thought of as economic earnings before tax.

Exhibit 1: BX Stock Fluctuation vs S&P at Key Economic Points

Source: William Blair, BX Initiating Report

Exhibit 2: Accelerated Growth of Alternative Asset Allocations

(Source: McKinsey, Preqin, ARES investor deck from Nov 17, 2015)

Exhibit 3: Intrinsic Value Per Share

Source: 2014 Blackstone Analyst Day

Exhibit 4: Investment record of significant drawdown funds from inception through June 30, 2016

Catalyst

X. CATALYSTS

• Management expects to achieve double digit growth in fee-related earnings through 2016 / 2017. As BX deploys capital and recurring management fees become a more significant part of overall earnings, BX should see a positive re-rating on its earnings multiple.

• 2016 will see the first full year of management fees from BREP VIII, Blackstone’s $15.8Bn flagship real estate fund launched in October 2015.

• BCP VII ($18Bn flagship private equity fund) has a scheduled 6-month fee holiday through most of 2016, but will be contributing a full year of FRE by 2017.

• Removal of negative sentiment overhang from Brexit and interest rate worries

• Deployment and monetization of $90Bn in AUM that is not currently earning management fees. Relative to the current fee earning AUM base of $266Bn, this represents a 34% increase

• Positive revaluation of major investments upon exit. Real estate and private equity holdings typically see a 20-30% gain on sale.

XI. INVESTMENT RISKS

• BX is a high-beta stock that trades on macro-indicators and credit markets sentiment (see Exhibit 1), and short-term reported results are tethered to financial market health. In a tighter capital environment, Blackstone may see reduced exit opportunities, asset outflows, and ENI declines, as well as reduced credit availability

• Key man risk upon Steve Schwarzman’s retirement

• The $2.9T hedge fund industry is expected to lose up to 25% of assets over the coming year due to underperformance

• This risk is at least partially negated share gains; between 2015 and Q1-2016, BAAM saw $6Bn of net inflows, while other secondary platforms (e.g. Carlyle’s) were shut down.

• BX’s PTP structure presents corporate governance risks;  management has disproportionate voting rights relative to their economic share

• Blackstone is sensitive to regulatory changes, for example, those governing co-investment allocations, reporting transparency, and the taxation of carried interest