Blackstone (BX) is quite possibly one of the most misunderstood companies trading on the US exchanges.  The company is listed as a “global alternative asset manager,” but few people adequately grasp the manner in which the company creates value for shareholders.  Reported earnings do very little to paint a picture of shareholder value as the company holds investment portfolios that may grow in asset value for considerable periods without ever actually being converted to earnings.  Furthermore, the assets that the company owns are to a large degree unpriced and very difficult to value.  It is not until part each individual holding is sold to the public markets that the company can confidently predict what the current value of the individual holding might be.

Part of the reason Blackstone’s shares have declined is due to fear over the company’s exposure to the liquidity crisis.  This crisis has been a vicious phenomenon for many financial institutions and at this point appears to have taken down at least one brokerage (Bear Stearns).  The environment calls into question how adequately Blackstone is funded and how much risk they have to redemptions.  However, the company is extremely well capitalized and at this time is not employing leverage.  Investors in the firms multiple strategies are for the most part required to give adequate notice before pulling their capital out and in some cases are not allowed to redeem their investment for years.  This allows the company to invest with a long-term value creation mindset without worrying about short term disruptions in the credit market.

As far as earnings are concerned, the company receives management fees for the capital it manages for investors in its various funds.  The company also invests its own capital alongside investors.  The management fees are helpful in paying salaries and carrying on the day to day business of Blackstone as a whole, but they do not add significantly to the profitability of the firm.  The key to the company’s success are incentive allocations which are essentially profit sharing arrangements with investors in the company’s funds.   When a position is sold for a gain, Blackstone recognizes a gain on its book for the portion of its own capital it invested as well as a portion of the gain its investors received (usually 20%).  These gains can amount to tens and even hundreds of millions of dollars and are vital in the company’s reported earnings.  The problem is that due to market conditions, these earnings have been largely absent for the last two quarters.

Looking at today’s environment, there are some interesting dynamics lining up.  Firstly, the company continues to accumulate assets under management (AUM).  This supplies Blackstone with ample cash to be able to purchase investments during a time when such investments are very cheap.  Investments made today could result in huge incentive allocations in the next 18 to 36 months.  Secondly, the IPO market is likely to pick up now that Visa (V) has successfully launched its IPO.  Investors should be more confident in purchasing new issues int he coming months which will likely result in Blackstone being able to turn out some of its portfolio of private investments resulting in incentive allocations.  Finally, the stock is incredibly depressed offering investors a chance to pick up shares for less than half of their IPO price.  While timing is difficult and volatility will likely cause some major swings, the shares are in a range that should prove to be a strong support area and one with less risk compared to the potential reward.  Beginning to build a position in BX at this time could yield significant gains throughout the next year or two.

FD: Author has a long position in BX