The Blackstone Group LP (BX) - Silver Linings

Categorized | Long Ideas

Blackstone Group (BX) – Silver Linings

Posted on 09 March 2009

The Blackstone Group L.P. (BX) has rebounded sharply after reporting earnings late in February. “Reporting earnings” is probably not the right term to use since the actual report was a significant loss. Still, the markets had already priced in a dismal picture as the stock had fallen to less than $4.00 per share. Keep in mind, Blackstone issued its initial offering at $31 so investors had seen their capital cut by more than 87%.

Despite the ugly fourth quarter, management gave investors reason to hope as several business metrics are actually holding up better than expected. Blackstone has a complicated business structure that is often misunderstood. So in order to be comfortable investing in the company, one must first understand the way Blackstone makes money.

Blackstone was originally set up as a Limited Partnership which managed investment funds. With this structure, investors are “limited partners” and they rely on the “General Partner” to invest their assets into the specific opportunities. The investment capital is bundled into a partnership and each partner shares in the gains and losses of the whole entity.

Now in this situation, the General Partner usually charges a management fee (often 2% of assets) as well as incentive fees. The incentive fees are the most profitable part of the business but also the least predictable. For instance, if the fund had $5 billion in initial capital and realized a 50% gain (profits of $2.5 billion), the General Partner would receive a portion of that $2.5 billion in profit. On the other hand, if the investment vehicle didn’t make any money, or lost money, the General Partner would only receive the management fee and no incentive fee.

Now that Blackstone is a public company, shareholders get much the same deal as the General Partner under the original structure. The company receives management fees for “fee paying assets under management” and also receives incentive fees for gains in the different investment funds managed by the company. (Yes in fact these funds are expected to post gains at some point along the way). Recently, the losses posted by the company have essentially been reversals of incentive fees that the company had booked on previous gains.

A common misconception is that Blackstone (and other private equity companies) are deeply in debt due to the leverage they use. In truth, the company as a whole has a healthy cash balance which more than adequately covers any company level liabilities. The leverage comes in on the investment fund level where certain investment partnerships have borrowed capital to make purchases. For instance, a fund may have $5 billion in invested capital, and then borrow another $5 billion in order to make $10 billion worth of investments. But Blackstone as a company does not borrow the money – only the individual investment fund.

Now despite the ugly market and the losses in private equity and real estate funds, these funds are actually attracting new investors and raising capital. This means more fee-paying AUM (Assets Under Management) and the potential for significant incentive allocations down the road when investments actually begin to appreciate rather than decline. Currently, Blackstone funds are sitting on $25 billion in dry powder, capital that is available to invest at what appears to be a buyers market.

The $25 billion is divided almost evenly between Private Equity funds and Real Estate funds. If this capital gets put to work in attractive situations, the net result could be very beneficial a year or so down the road. Investors are already beginning to anticipate returns on this capital which is why we see the stock ramping significantly.

One surprise from the earnings call was that the company will not pay out its fourth quarter dividend. This is probably a wise move aimed at keeping the company well capitalized until they begin to recognize gains again. Barclays issued a report last week that voiced confidence that the dividend will be paid for 2009 which would give investors a little income while waiting for returns to come in. I believe the dividend is not an important part of owning the stock at this point. Obviously once earnings begin to come in, it makes sense to distribute the cash to shareholders, but for the time being, I’m encouraged with a responsible conservation of cash.

As I look to the year ahead, I believe Blackstone has strong potential to make back much of its losses. New capital put to work can quickly lead to incentive gains since there is not a high water mark to make up. The stock still appears to be an attractive value even after last week’s gains. The picture will definitely take some time to clear, but by the time we see positive fundamentals, the stock will likely already be much higher.