BEST DAYS OF PRIVATE EQUITY FIRMS COULD LIE IN THE PAST / THE FINANCIAL TIMES COMMENT & ANALYSIS

Smart Money

June 23, 2014 8:31 am

Best days of private equity firms could lie in the past

By Henny Sender

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In mid-June, Blackstone held its second ever investor day in a valiant effort to coax its share price higher. Seven years after the firm went public at the height of the market frenzy, shares at the biggest alternative firm finally trade at just over $33 a share, above the $31 at which it listed.

The stock market has set new highs in June, credit market investors are desperate for the high yields that levered buyouts and refinancings offer, and private equity firms like Blackstone are arguably the biggest beneficiaries of quantitative easing, a policy which treasures borrowers over savers. Blackstone describes itself as the most profitable asset management firm in the world.

So why aren’t the share prices of Blackstone and its peers performing more strongly? Are investors missing something or could it be that the best days of the listed private equity firms lie in the past?

Blackstone’s founder Steve Schwarzman has long been vexed by the failure of the stock market to recognise what, in truth, is an amazing performance. In Blackstone’s last earnings call back in April, he could not resist comparing BlackRock’s “really really good quarter” with that of Blackstone.

“I just wanted to point out that we are not so bad either,” he added, as he went over various comparative figures, all to BlackRock’s detriment, including a generous dividend yield of 4.3 per cent for his shares.

Blackstone executives elaborated on Mr Schwarzman’s claims on investor day. Despite the fact that its earnings are growing at a 31 per cent rate, triple that of traditional asset managers, the stock market has given Blackstone a price-to-earnings ratio of 10 times estimated 2014 earnings compared to 16 times for the more traditional managers.

Its market cap, at $38bn, is a small sliver of that of its more boring rivals. Blackstone has the most diversified business model and revenue streams of all the alternative firms, with its real estate business (which accounts for 28 per cent of fees) in a class of its own, and credit, usually a low risk, low return business, accounting for another 18 per cent. Its private equity business has stumbled far less than any competitor.

All this is impressive by the standards of its industry.

But, at the same time, there are good reasons to be cautious at this point, both because of what is going on in the markets and what is going on in the industry.

Until now, for example, the private equity firms have been the biggest beneficiaries of the regulators’ focus on the banks and their determination to make them safer, less risk taking creatures.

That is why Goldman Sachs’ return on equity was 11 per cent in 2013, while KKR, which is the only private equity firm to calculate return on equity, had a 27.4 per cent return on equity. In 2007, Goldman’s return on equity was more than 30 per cent.

But now the regulators seem to be turning their attention to the private equity firms. Regulatory scrutiny on the structure of fees, for example, will probably have some impact on the proclivity of most private equity firms to charge their portfolio companies fees for a variety of services.

Often, best practice means less lucrative practice, sadly. And growth in fees is a big part of what analysts pay attention to when they decide whether to recommend the shares of the big private equity firms.

Moreover, it used to be that having lots of dry powder – and Blackstone has $48bn in dry powder – was a good thing. But now investors fret that the vast sums of money the industry has raised cannot be deployed as profitably as in the past.

Global M&A is up 68 per cent year to date. Yet all the big deals this year have been done by strategic investors, while private equity has been left to sit on the sidelines as valuations rise. The capital market specialists at private equity firms say that this will soon change but so far, in many cases, they have been buying and selling with each other, something their investors hate.

And, finally, there is growing concern about the next stage in the market for high yield credit. “Credit is the faster growing risk asset class, and thus relatively more over-owned by end investors,” noted Jan Loeys, strategist for JPMorgan in a research note on June 13, as the firm reduced its overweight in credit.

“Spreads have fallen to levels not far from past cycle lows. Issuers are starting to leverage up, and investors are beginning to worry about how the eventual exit will fare in a world of reduced market making by banks.”

Blackstone’s investor day material includes the proud boast: “The Alternatives have Evolved.” But whether their public shareholders will be the beneficiary of that evolution is not clear.

Copyright The Financial Times Limited 2014.