The Value of Blackstone's Business -- Part One

It's a veritable feast for the discerning investor's eyes: 37% compound annual revenue growth, 65% operating margins, $3 million in profit per employee, returns on invested capital in the triple digits. And a cherry on top.

Okay, so maybe we lied about the cherry. But not the rest--you're looking at the actual results of an honest-to-goodness company.

Meet the Blackstone Group
Well, not just any company. The Blackstone Group is arguably the uber-buyout firm. Led by billionaire cofounders Steven Schwarzman and Peter Peterson, Blackstone has gone from relative obscurity to global renown in the span of roughly two decades, parlaying a penchant for deal-making and a yen for competition into a war chest that now brims with billions of dollars in investment capital.

While Blackstone was already a fixture in the headlines given its seemingly insatiable hunger for deals, the firm's profile has come into even sharper relief recently. The reason? Following the lead of  Fortress Investment Group , which recently went public, Blackstone has registered with the SEC to auction off a portion of the firm in an initial public offering.

Blackstone's preliminary offering document--from which we culled the statistics above--lays bare the firm's eye-popping profitability and prodigious growth. Yet, investors mulling an investment in Blackstone will have to wrestle with the question of whether the good times will continue to roll and, more to the point, what price to pay for the stock.

What You're Getting Into
Before drilling down into the details, it's worth quickly reviewing what an investment in Blackstone Group shares would buy: a share of the firm's earnings stream.

Stated differently, an investment in Blackstone shares does not buy a stake in the private equity and hedge fund partnerships that do the actual buying and selling of securities. Thus, if you were viewing a Blackstone Group investment as an opportunity to rub elbows with the high rollers in the institutional or high-net-worth set, think again.

Not that you should despair at the prospect of owning a piece of Blackstone. Put simply, the firm practically mints money. Blackstone's earnings emanate from a few sources--management fees, incentive fees, and transaction fees. Management fees are levied on assets under management at a contractually stipulated rate. Though the amount of the fee can vary, Blackstone's private equity and hedge funds normally charge between 1% and 2%. Since these fees are tied to the level of assets under management, Blackstone benefits as investors pump more money into its various partnerships.

Whereas traditional asset managers levy a more-or-less fixed fee on assets under management, alternative managers can also earn an incentive fee--typically 20%--on profits exceeding a specified hurdle rate. In the case of Blackstone's private equity funds, that hurdle rate is generally 7% to 9% while it's zero on the hedge funds. Thus, the better a fund does in absolute terms, the more it stands to earn in incentive fees. (Blackstone uses the term "carried interest" to describe the incentive fee that it levies on its private equity and real estate opportunity funds.)

The third source is transaction fees levied on companies that one or more Blackstone private equity funds have acquired, which are meant to compensate Blackstone for taking a firm private, restructuring or recapitalizing the business, and positioning it for eventual re-entry to the public markets or sale to another party. Though euphemistic sounding ("transaction consummation fee," "monitoring fee," "disposition fee"), these fees can be enormously lucrative. Blackstone stands to earn as much as 1% of the enterprise value of the companies it acquires, a staggering sum when one considers that, since entering the business in 1987, the firm's private equity funds have consummated 300-plus transactions with an aggregate enterprise value approaching $300 billion.

Apart from this fee income, Blackstone also makes money by investing its own capital alongside limited partners in its private equity and hedge funds. Thus, as those funds rack up gains and income, Blackstone shares in the spoils.

These fees add up to an awe-inspiring degree: Blackstone pulled down $747 million in fee-related earnings in fiscal 2006 on $1.16 billion in fee revenue. Taken together with roughly $1.5 billion in investment gains that the firm salted away last year (roughly $1.2 billion of which was carried interest relating to investment gains that various private equity and real estate funds realized over the course of last year), Blackstone's profits verged on the stratospheric--the firm managed to notch a roughly 200% net margin.

A Delectable Business Model
Asset management is a scalable business in general, as firms need not throw droves of additional people at each new investment management mandate. Rather, such firms can effectively tap existing processes, such as the thinking of a given manager, in order to service each new piece of business. This partly explains the attractive underlying economics of the asset-management business, which is typically characterized by plump profit margins (operating margins exceeding 25% are the norm) and relatively low capital investment needs (returns on invested capital often surpass 50%).

If anything, these attributes are more pronounced with an alternative investment manager like Blackstone, as a large portion of the incentive fees that the firm earns falls to the bottom line. Moreover, since the firm's institutional focus largely obviates the need for heavy marketing and distribution expenditure, new business yields even fatter profits than might accrue to, say, a retail-focused money manager. These factors play a large part in explaining Blackstone's outsized profits.

Having Their Free Lunch and Eating It, Too
Of course, since there are no free lunches, you'd expect Blackstone's earnings stream to be more volatile than a traditional asset manager's. After all, the incentive fee structure seemingly exposes the firm to the vagaries of investment performance which, in turn, are influenced by the capital market's gyrations.

Nevertheless, several countervailing factors should continue to provide ballast. For one, only 20% of Blackstone's management fees are based on the net asset value of the underlying funds. In the case of Blackstone's private equity funds, management fees are based on the amount of capital that investors commit, not the value of the investments. Consequently, even if Blackstone's private equity investments were to decline in value, management fees would not necessarily follow suit.

The asset base is also likely to be a good deal stickier than a traditional asset manager's for a few reasons. First, unlike most managed investment vehicles, private equity funds have finite lives, often ranging from eight to 10 years. The upshot is that once a private equity manager raises capital for a fund, those capital commitments are captive for the life of the fund, effectively foreclosing the possibility of investor redemptions. This stabilizes Blackstone's base of management fee revenue while freeing management to invest with a suitably long time horizon.

Provisions limiting redemptions from various Blackstone hedge funds also help stabilize asset flows. Redemption limits notwithstanding, investors have a built-in incentive to stay put given that redemptions can force management to sell illiquid investments at steep discounts to fair value, thereby diluting a selling investor's take.

In addition, the largely institutional make-up of Blackstone's client base confers stability, as such investors are, generally speaking, less prone to performance chasing.

Finally, Blackstone, by virtue of its controlling interest in the typical private equity portfolio company, can levy various transaction fees, the timing and amount of which are largely at its discretion. Blackstone must toe the line in reaping such dividends; transaction fees essentially dilute the value of the portfolio company concerned, and excessive charges could limit the company's financial flexibility or depress the value the company would ultimately fetch in a subsequent IPO or private sale. However, this option affords a form of downside protection, allowing the firm to monetize a portion of its investment prior to cashing out.

Valuing Blackstone
With such a strong business model, readers might be wondering whether it's worth taking the dive. In next week's concluding article, we'll discuss some of the risks that Blackstone's business and (still unpriced) shares could face--and whether potential investors would be smart to proceed with caution.