Blackstone's Diversification and Solid Fundraising Helping Firm Mitigate Impacts of M
Blackstone's Diversification and Solid Fundraising Helping Firm Mitigate Impacts of Market Downturn
Analyst Note| by Greggory WarrenUpdated Oct 21, 2022
We've lowered our fair value estimate for narrow-moat-rated Blackstone to $115 per share from $125 after updating our valuation model to include weaker equity and credit market returns in the near term, which will have a negative impact on assets under management. Our new fair value estimate implies a price/earnings multiple of 22.2 times our 2022 estimate, 20.5 times our 2023 estimate, and 16.4 times our 2024 estimate for distributable earnings per share (which remove the effects of unrealized activity). For some perspective, during the past five (10) years, the company's shares have traded at an average of 23.5 (23.5) times trailing distributable earnings.
Blackstone closed out September 2022 with $705.9 billion in fee-earning AUM, reflective of a 33.6% year-over-year increase. Adjusted net inflows (which include distributions and realizations) of $65.7 billion during the first nine months of 2022 were impressive considering the disruption in the equity and credit markets (with the quarterly run rate over the prior two calendar years being $25.5 billion). We had envisioned a slower year for capital deployment in 2022 after a record year of inflows during 2021, but the downturn in the equity and credit markets seems to have provided a near-term boost. Despite the selloff in the equity and credit markets this year, we continue to expect organic AUM growth to be solid in the near term (given the strength of Blackstone's fundraising pipeline) but don't envision the company hitting its target of $1 trillion in total AUM until sometime in 2023, still well ahead of management's target of 2025-26 to reach this milestone. Blackstone closed out September 2022 with $950.9 billion in total AUM.
Business Strategy and Outlook| by Greggory WarrenUpdated Oct 21, 2022
We consider Blackstone to be the preeminent alternative asset manager, with $950.9 billion in total assets under management, or AUM, including $705.9 billion in fee-earning AUM, at the end of September 2022. The company has scale in each of its four business segments: private equity (24% of fee-earning AUM and 31% of base management fees), real estate (39% and 40%), credit & insurance (27% and 20%), and hedge fund solutions (10% and 9%). Blackstone has also built out a large base of employees--including in-house executives, consultants, and advisors--that have decades of industry experience and can successfully revitalize a company or property through cost-cutting, acquisitions, or other strategic maneuvers.
These attributes have provided Blackstone with the ability to not only gather but retain assets in various market conditions as well as a means of differentiating itself from peers. The firm booked $44.8 billion in capital inflows during the third quarter of 2022 (and $337.8 billion over the past year), with the company currently being midway through its largest fundraising cycle ever and currently sitting on $181.9 billion in dry powder ($85.2 billion in private equity, $60.5 billion in real estate, $29.7 billion in credit alternatives, and $6.5 billion in hedge fund solutions).
Blackstone continues to be our top pick among the three alternative asset managers we cover, despite each of them benefiting from the tailwind provided by ongoing demand for alternative products by both institutional and retail-advised clients. While both KKR & Company and Carlyle Group sometimes trade cheaper on a price/earnings and a price/fair value basis than Blackstone, the former has become more complicated by its majority stake in Global Atlantic Financial Group, a life insurer with heavier exposure to the equity markets, while the latter is on the smaller side relative to the other five large publicly traded alternative asset managers in an industry where investors are increasingly focused on firms that have meaningful scale in each of the four main segments of the market.
Economic Moat| by Greggory WarrenUpdated Oct 21, 2022
We believe that the asset-management business is conducive to economic moats. Unlike the traditional asset managers (such as BlackRock, T. Rowe Price, and Franklin Resources), which focus more heavily on traditional asset classes like equity, fixed-income, balanced and money market funds, alternative asset managers like Blackstone focus on less-liquid alternative investments like private equity, credit alternatives, real estate, and hedge funds. Even so, we think the traditional and alternative asset managers both benefit from switching costs (the core moat source) and intangible assets, including organizational attributes--such as product mix, distribution channel concentration, and geographic reach--and true intangibles--like strong and respected brands and manager reputations derived from successful, maintainable track records of investment performance--that explain why an asset manager might vary from the switching cost advantage inherent in the industry.
Blackstone has, in our view, built a solid position in the industry, utilizing its reputation, broad product portfolio, investment performance track record and cadre of dedicated professionals to not only raise massive amounts of capital but maintain the reputation it has built for itself as a "go-to firm" for institutional and high-net-worth investors looking for exposure to alternative assets. During the past five to 10 years, the company has produced ROICs that have generally been 400 basis points to 900 basis points above our estimated cost of capital. While we expect the firm to expand its level of excess returns over the next five to 10 years (given the level of interest that still exists for alternatives) we believe it will become increasingly more difficult for the company to consistently generate an abundant level of excess returns beyond that period as increased competition from peers, continued pressure on fees, a higher overall tax rate (after converting from a publicly traded partnership to a corporation) and a general maturation of the industry (from a solid period of above average growth in the face of shifting investor demand for alternatives) weigh on results. As such, we believe the firm has only a narrow economic moat around its operations even though it exhibits characteristics of a wide-moat firm.
Unlike the more traditional asset managers, who have had to rely on investor inaction (driven by either good fund performance or investor inertia/uncertainty) to keep annual redemption rates low (generally in a 20%-30% range for long-term AUM), the products offered by alternative asset managers can have lockup periods attached to them, which prevent investors from redeeming part or all of their investment for a prolonged period of time. Generally, we favor longer lockup periods, which offer up more substantial switching costs, with private equity tending to offer the longest lockup periods of seven to 10 years compared with quarterly for most hedge funds and fund of fund products (after a specified period of time has passed from the initial investment). This arrangement has allowed Blackstone to post an annual redemption (retention) rate of less than 10% (more than 90%) on average the past five/10 years even with about a third of its total and fee-earning AUM tied up in products redeemable on a quarterly basis.
We believe the alternative asset managers, much like the traditional asset managers, can improve on the switching cost advantage inherent in their business with organizational attributes (such as product mix, distribution and geographic reach) and intangible assets (such as strong and respected brands and manager reputations derived from successful, maintainable track records of investment performance) and provide them with a degree of differentiation from their peers. While the barriers to entry are not all that significant for the industry, the barriers to success are extremely high as it not only takes time and skill to put together a long enough track record of investment performance to start gathering assets but even more time to build the scale necessary to be competitive (exemplified by the fact that BlackRock is the only legitimate traditional asset manager of size competing in this part of the market despite the fact that most of our coverage has been focused on building out their alternative asset manager offerings during much of the past decade).
This scenario has provided the larger, more established asset managers with an advantage over the smaller players in the industry, especially when it comes to gaining cost-effective access to distribution platforms as well as handling many of the operational improvements that are now required to drive value creation in private equity and real estate portfolios. The publicly traded alternative asset managers are global institutions with decades of experience investing in nontraditional asset classes, primarily by managing money for private and public pension funds, endowments, foundations, and other institutions, as well as for high-net-worth individuals that qualify as "sophisticated investors" (those with sufficient capital, experience and net worth to engage in these less liquid investment opportunities that generally require high minimum investments on the part of investors). Most of the industry's largest players--Blackstone, Apollo, KKR and Carlyle--started off in private equity but have expanded their reach over time to include credit, real estate, hedge funds and funds of hedge funds. Being more broadly diversified, and having a solid investment performance track record, has enhanced Blackstone's switching cost advantage, in our view.
Blackstone is one of the oldest stand-alone alternative asset managers, with many of its funds started some 10 to twenty years ago. The firm is the largest stand-alone alternative asset manager in the world with $950.9 billion in total AUM, including $705.9 billion in fee-earning AUM, at the end of September 2022. Blackstone operates with scale in each of its major product lines--private equity (with $283.3 billion in total AUM and $167.3 billion in fee-earning AUM), real estate ($319.3 billion/$273.4 billion), credit & insurance ($269.1 billion/$193.7 billion), and hedge fund solutions ($79.3 billion/$71.4 billion)--and distribution channel--institutional (87% of total AUM) and high-net-worth (13%)--where it competes, with a global reach that includes 25 offices in the Americas, Europe/Middle East, and the Asia-Pacific region. And much like its peers, Blackstone has built out a large base of employees--including in-house executives, consultants and advisors--that have decades of industry experience and can successfully revitalize a company through cost-cutting, acquisitions, or other strategic maneuvers, increasing the chance of producing a successful investment.
All of these attributes have provided Blackstone with the ability to not only gather but retain assets in various market conditions, as well as a means of differentiating itself from peers. During the past five years, an overwhelming majority of the capital in the alternative assets category was held in private equity/venture capital funds (54% of industry capital on average), with the remainder held in private debt (11%), real estate/real asset (23%), and other alternatives (12%) offerings. Blackstone, in our view, is well positioned to compete for business in each of these segments given its existing scale across these key product areas, which makes it a contender for new assets in most cases (especially given its access to more than 1,000 institutional investors already invested in its funds). The company was the largest fundraiser among the stand-alone publicly traded alternative asset managers during the past decade, pulling in just over $1.0 trillion with its private equity ($252 billion), private debt ($388 billion), real estate/real asset ($288 billion), and other alternative funds ($108 billion) during 2012-21.
During the past five (10) years, the company accounted for 29% (25%) of the industry's private debt segment fundraising, 16% (12%) of new commitments for real estate/real asset funds, 5% (5%) of the capital being raised for private equity/venture capital funds, and 13% (14%) of fundraising in the other alternatives category. As a result, Blackstone accounted for 12% (10%) of new commitments to alternative products during 2017-21 (2012-21). On top of that, the firm gathered as much capital during the past five (10) years as its next two largest stand-alone competitors--Apollo Group and KKR--in the alternative asset-management segment combined.
That said, competition for investor capital can be stiff and has traditionally centered on manager reputation, fund size and investment performance. In a sign that fundraising competition has intensified during the past decade, there was a five-year period following the 2008-09 financial crisis where Blackstone was raising more investor capital than its next four largest peers--Apollo Group, KKR, Ares, and Carlyle Group--combined (compared with its two largest stand-alone competitors the past couple of years). We expect competition for new investor capital will only increase in the future, especially with more traditional asset managers like BlackRock increasing their exposure to alternatives and showing a willingness to be fungible on fees (given that management and performance fees in this part of the market are significantly higher than what most traditional asset managers earn with their core product offerings).
Fair Value and Profit Drivers| by Greggory WarrenUpdated Oct 21, 2022
We've lowered our fair value estimate for Blackstone to $115 per share from $125 after updating our valuation model to include weaker equity and credit market returns in the near term, which will have a negative impact on assets under management. Our new fair value estimate implies a price/earnings multiple of 22.2 times our 2022 estimate, 20.5 times our 2023 estimate, and 16.4 times our 2024 estimate for distributable earnings per share (which remove the effects of unrealized activity). For some perspective, during the past five (10) years, the company's shares have traded at an average of 23.5 (23.5) times trailing distributable earnings, with the average being closer to 25.3 times since Blackstone became a C-Corp in 2019. We use a 21% U.S. statutory corporate tax rate and a 9% cost of equity in our valuation.
Blackstone closed out September 2022 with $705.9 billion in fee-earning AUM, reflective of a 33.6% year-over-year increase. Adjusted net inflows (which include distributions and realizations) of $65.7 billion during the first nine months of 2022 were impressive considering the disruption in the equity and credit markets (with the quarterly run rate over the prior two calendar years being $25.5 billion). We had envisioned a slower year for capital deployment in 2022 after a record year of inflows during 2021, but the downturn in the equity and credit markets seems to have provided a near-term boost.
Despite the selloff in the equity and credit markets this year, we continue to expect organic AUM growth to be solid in the near term (given the strength of Blackstone's fundraising pipeline), but don't envision the company hitting its target of $1 trillion in total AUM until sometime in 2023, still well ahead of management's target of 2025-26 to reach this milestone. Blackstone closed out September 2022 with $950.9 billion in total AUM.
We expect Blackstone to generate above-average adjusted organic fee-earning AUM growth of 7.9% (6.8%) annually during 2022-26 (2022-31) and produce adjusted operating margins of 49.2% (50.5%) on average annually the next five (10) years. While realizations are difficult to predict, we believe Blackstone will continue to benefit from the fee-based components of its earnings (even with fees eventually being pressured) as fee-paying assets increase in size over time. Our 2022, 2023, and 2024 distributable earnings per share estimates of $5.19, $5.60, and $7.00 per share, respectively, reflects our expectations for fee-based earning growth and more normalized realizations over time.
While our base-case scenario generates a fair value estimate of $115 per share, we project a bull-case fair value estimate of $178 per share and a bear-case valuation of $69 per share. The key factors affecting our scenario analysis include Blackstone's level of fee-earning AUM, its pricing power and realized performance fees, and its ability to continue to raise capital in the future.
Our upside case leads to a fair value estimate of $178 per share, which implies a P/E multiple of 27.4 times our 2022 earnings estimate, 25.4 times our 2023 earnings estimate, and 20.3 times our 2024 earnings estimate. This scenario assumes stronger equity market returns, capital-raising efforts, and realization levels than we are projecting in our base case. We would expect to see this scenario amid a period of very strong fund investment returns, but it would also reflect an improved ability for Blackstone to attract qualified personnel to run its fund-acquired companies as well as develop new fund strategies.
With fee compression also being less of an issue, the net result would be a positive 14.6% CAGR for base management fees during our five-year forecast period (compared with positive 12.4% in our base case), with total revenue increasing at a negative 2.1% (positive 20.3%) CAGR during 2022-26 (2023-26). Distributable earnings per share would also be 20%-25% higher on average annually.
Our downside case leads to a fair value estimate of $69 per share, which implies a P/E multiple of 17.7 times our 2022 earnings estimate, 16.4 times our 2023 earnings estimate, and 13.1 times our 2024 earnings estimate. This scenario, in contrast with our base case, assumes weaker equity market returns, lower levels of capital-raising, and lower levels of realizations due to unpalatable markets. We think such a scenario could occur if fund investment returns falter, but also if Blackstone struggles for a time to successfully market and develop new fund strategies.
With fee compression expected to be a larger issue than in our base-case forecast, the net result would be a positive 7.5% CAGR for base management fees during our five-year forecast period, with total revenue increasing at a negative 7.4% (positive 12.3%) CAGR during 2022-26 (2023-26). Distributable earnings would also be 20%-25% lower over the course of our projection period.
Risk and Uncertainty| by Greggory WarrenUpdated Oct 21, 2022
Our Morningstar Uncertainty Rating for Blackstone, which includes assessments of the firm's environmental, social, and governance issues, is High. Blackstone's private equity and real estate investments are highly illiquid. Tightened credit conditions could limit the firm's ability to move into new investments, while weak economic conditions and difficult equity and credit markets could affect not only the value of Blackstone's investments, but also its ability to cash out of these investments. The firm's real estate segment is also subject to the risks inherent in the ownership and operation of real estate and related businesses and assets. Our fair value estimate currently anticipates modest annual reductions in base management and incentive/performance-based fees. Should fees compress at a far greater rate than we are anticipating, it would have a major impact on the firm. Poor investment performance can also affect revenue, profitability, and cash flows and potentially obligate the firm to repay carried interest earned in prior periods. It could also have a negative impact on the company's ability to raise new capital for future investment funds, given that limited partners typically recycle distributions from earlier funds into new ones. Given its global footprint, the firm is exposed to cultural, economic, political, and currency risks, while further changes in relevant U.S. and foreign tax laws, regulations or treaties could adversely impact Blackstone as well. While the company is at a lower risk of experiencing material financial impacts from ESG factors, its medium exposure to risks that are inherent to the industry, as well as its own operations, are complicated by its weaker corporate governance.
Capital Allocation| by Greggory WarrenUpdated Oct 21, 2022
Chairman and CEO Stephen Schwarzman cofounded Blackstone in 1985 and has been involved in all phases of the firm's development since that time. Lines of succession have been relatively clear over the years, with Jonathan Gray (formerly head of the firm's real estate segment) succeeding Hamilton Evans "Tony" James (who now serves as executive vice chairman) as president and COO in February 2018. We believe that Schwarzman and the other general partners at Blackstone have run the firm about as effectively as possible in the decade following the 2008-09 financial crisis, taking full advantage of the dislocation in the equity and credit markets during that time to expand the company's operations--primarily in real estate and credit--thereby reducing the firm's exposure to the vagaries of the private equity market. While the firm did convert from a publicly traded partnership into a corporation in July 2019, Blackstone's partnership units continue to account for around 45% of total shares outstanding (with Schwarzman holding over half of that amount).
Our capital allocation rating for Blackstone is Standard. This rating assesses management efficacy based on three key areas: balance sheet health; investment efficacy; and shareholder distributions. Given that a firm's financial health directly affects its ability to invest in future growth opportunities, return cash to shareholders, or even remain a going concern, it is important to pay attention to balance sheet strength. Asset managers, in particular, have a high degree of revenue cyclicality and operating leverage (with results tending to be impacted by the vagaries of the markets) and are generally asset light. As such, they should not maintain more than low to moderate levels of financial leverage. Blackstone, in our view, has maintained a sound balance sheet, highlighted by $3.5 billion in cash and equivalents, $7.5 billion in investments, $7.1 billion in accrued performance revenue and $9.4 billion in long-dated debt (on a principal basis) on its books at the end of September 2022. The company has historically had low debt/total capital and debt/EBITDA levels, and we expect that going forward net debt/adjusted EBITDA (as well as to enterprise value) to remain very low. Just under 10% of the company's outstanding debt is due during the next three years.
Blackstone believes its ever-increasing scale, diversified business offerings, long track record of investment performance, rigorous investment process, and strong client relationships position the firm to not only perform well in a variety of market conditions but expand its managed assets and add complementary businesses. The company's long-term strategy has been focused on the fundraising, investment, and realization phases of its private equity, real estate, credit (and insurance), hedge fund offerings, as well as returning capital to shareholders. Fundraising has more recently shifted away from Blackstone's more traditional model of using finite-lived, long-dated funds to invest in underperforming companies and assets (using cost cuts and efficiency improvements to improve those operations while also lifting returns through the strategic use of debt) to a mix of both finite-lived, long-dated funds and "perpetual capital" (funds with an indefinite term that is not in liquidation, and for which there is no requirement to return capital to investors through redemption requests in the ordinary course of business).
The company looks to deliver differentiated investments through new fund strategies (like the firm's efforts the past several years with infrastructure, insurance, life sciences, and technology funds). Blackstone's business heads have been encouraged to think more thematically about investing and identify global trends (like logistics, life sciences, software, and digital payments more recently) where the firm can put money to work for the benefit of its limited partners (the institutional and retail investors that commit capital to their funds) and, ultimately, the firm's shareholders. On the distribution front, share repurchases have been rare over the past decade, with the company repurchasing (net of issuances) just over $3 billion of stock (most of which was bought back in the past four calendar years). Dividend payments, meanwhile, exceeded $25 billion during the same time frame and are expected to account for 85% of distributable earnings annually going forward.